Taxes in Your Practice: Year-end tax planning for 2020
Vol. 76, No. 6 / Nov. - Dec. 2020
Scott E. Vincent
Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.
The 2020 pandemic and economic crisis have brought tremendous upheaval for many taxpayers. As this article goes to press, we appear to have a change in the White House and control of the Senate is undecided. In addition to these challenges, taxpayers will need to consider provisions of the SECURE Act that went into effect late last year; the 2020 Families First Coronavirus Response Act (Families First Act or FFCRA); the 2020 Coronavirus Aid, Relief, and Economic Security Act (CARES Act); and additional pandemic relief programs and tax provisions.
Taxpayers will also need to consider planning for current and potential tax rates, the standard deduction and limits on itemized deductions, and multiple other issues, including continuing provisions of the Tax Cuts and Jobs Act of 2017 (2017 Tax Act). The § 199A deduction for qualified income from pass-through entities may also impact individuals and their businesses. This article outlines several of these individual and business planning issues, but taxpayers should adjust their planning for their particular circumstances and carefully monitor ongoing changes to the provisions outlined here and other new legislation.
Year-End Planning Issues for Individuals
- Review CARES Act rebates. Most individuals under applicable income levels already received stimulus checks for their recovery rebate tax credit. These checks were issued based on 2019 income tax returns, but the final calculation of the correct rebate amount is part of 2020 tax returns. If this calculation shows a larger rebate, it can be claimed as a credit against 2020 tax liability.
- Review student loan debt repaid by an employer. The CARES Act excludes amounts repaid by an employer in 2020 after March 27, 2020 from taxable income.
- Review credits and deductions, including the child and dependent tax credit and education-related credits and deductions. In addition, the Families First Act added sick leave and family leave credits for certain self-employed individuals.
- Consider the expanded standard deduction, eliminated personal exemptions, and limits on itemized deductions from the 2017 Tax Act. For 2020, there are no personal exemptions, but the basic standard deduction is increased to $24,800 for joint filers; $18,650 for heads of household; and $12,400 for singles and married taxpayers filing separately. Many itemized deductions are also either reduced or eliminated. So, unless allowable medical deductions (as limited by 7.5% of AGI), state and local taxes of up to $10,000, allowable charitable deductions, interest deductions on qualifying residence debt, and other allowable itemized deductions exceed the standard deduction, taxpayers may find that the increased standard deduction provides more tax benefit. For taxpayers with timing flexibility, there may also be an incentive for “bunching” allowable itemized deductions into one year and using the standard deduction in other years.
- Consider special charitable deduction rules for 2020. For taxpayers that itemize deductions, the CARES Act increases the maximum charitable deduction in 2020 from 60% of AGI to 100% of AGI. The CARES Act also allows a $300 above-the-line charitable deduction for taxpayers who do not itemize.
- Have an employer increase withholding of state and local taxes (or pay estimated tax payments of state and local taxes) before year-end for deduction of those taxes this year. This can be beneficial if a taxpayer expects to itemize deductions this year, and doing so will not cause state and local tax deductions to exceed the $10,000 limitation.
- Plan for the 3.8% tax on unearned income. This surtax is 3.8% of the lesser of: (1) net investment income (NII), or (2) the excess of modified adjusted gross income (MAGI) over a threshold amount (unindexed) of $250,000 for joint filers or surviving spouses, $125,000 married individuals filing a separate return, and $200,000 for other taxpayers. Year-end planning for the 3.8% surtax will depend on estimated MAGI and NII. Some taxpayers may want to defer additional NII until next year, some may want to reduce MAGI other than NII, and some may be able to minimize both NII and other MAGI.
- Consider the additional 0.9% Medicare tax. This tax applies to individuals receiving a combination of wages with respect to employment and self-employment income exceeding $250,000 for joint filers; $125,000 for married couples filing separately; and $200,000 for other filers. Employers must withhold the additional Medicare tax from wages in excess of $200,000. Self-employed persons must include it in estimated tax payments, and some employees may need more withholding to cover the tax.
- Accelerate income into this year in cases where a taxpayer’s marginal tax rate is expected to be lower this year than it will be next year due to economic conditions or expected changes in filing status or applicable rates. Postponing income can produce savings for taxpayers who expect to be in a lower tax bracket next year.
- Consider lower long-term capital gain rates on sales of assets held for more than one year. Depending on taxable income levels, taxpayers may want to utilize these lower rates for capital gain sales and avoid selling capital assets with offsetting losses that reduce the benefits of the lower rates. The reduced rates apply to adjusted net capital gain to the extent that this amount, when added to regular taxable income, does not exceed certain thresholds based on filing status. So, analysis of taxable income, potential capital gains, and other considerations like the NII surtax and Medicare tax is required to determine the best combination.
- Consider retirement plan contributions, including catch-up contributions of additional amounts for taxpayers 50 and older. The age limit of 70 1/2 for making retirement plan contributions was also repealed in 2020, so all eligible taxpayers can make traditional IRA contributions regardless of age.
- Certain retirement plan distributions are excepted from the 10% early withdrawal penalty. A qualified birth or adoption distribution of up to $5,000 is allowed. There is also a special coronavirus relief withdrawal of up to $100,000 from retirement plans, which is includable in income over a three-year period or eligible for tax-free rollover to an eligible retirement plan within the three-year period.
- Review required minimum distributions (RMDs) from retirement accounts. RMDs are waived for 2020, and the RMD beginning date for taxpayers changed from 70 1/2 to 72 starting with the 2020 tax year. Participants who are still working also may be able to further delay RMDs. However, taxpayers who fail to take RMDs can be subject to a penalty of 50% of the required amounts that are not withdrawn.
- Consider making charitable donations from traditional IRAs. Qualified charitable distributions are made directly to charities, and the amount is not included in gross income or itemized deduction calculations and limits. In addition, the qualified charitable distribution reduces RMDs when applicable. Taxpayers can plan for this benefit by maximizing contributions to traditional IRAs with amounts that may later be used for qualified charitable distributions.
- Consider a Roth IRA conversion. A taxpayer that would prefer a Roth IRA can convert traditional IRA investments into a Roth IRA if eligible. A conversion will increase AGI for this year, so taxpayers should consider the impact on other AGI tax calculations.
- For taxpayers eligible to make health savings account (HSA) contributions, consider a full year of deductible HSA contributions before the end of the year. HSA contributions are deductible from AGI, so the benefits are available even if a taxpayer does not itemize deductions.
- Increase the amount set aside for next year in a health flexible spending account (FSA) if the taxpayer did not set aside enough for this year. Earnings set aside in an FSA allow payment of medical and dental bills with pre-tax earnings.
- Complete annual gift tax exclusion gifts before the end of the year to save gift and estate taxes. This year, taxpayers can give $15,000 each to an unlimited number of individuals but cannot carry over unused exclusions from one year to the next. These transfers also may save family income taxes where income-earning property is given to family members in lower-income tax brackets who are not subject to the kiddie tax.
Year-End Planning Issues for Business Owners
- The CARES Act included the Paycheck Protection Program (PPP). The PPP generally provides for tax-free loan forgiveness based on expenditures in qualifying categories. For taxpayers participating in the PPP, forgiveness applications and timing should be considered, including carefully compiling records of PPP expenditures. Importantly, the treatment of forgiveness amounts and deductibility of expenditures relating to the PPP are still developing and certainly could change with further relief acts and a new administration.
- The CARES Act retroactively corrected a technical error in the 2017 Tax Act so that qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property are depreciable over a 15-year life (rather than 39 years under the technical error). This correction is retroactive, so taxpayers may be able to file amended returns for 2018 and 2019 as well.
- For 2020, the CARES Act removed the 80% limitation on taxable income eligible for reduction by NOL deductions. For tax years after 2020, NOL carryforwards from prior to 2018 will be deductible, along with post-2017 losses with an 80% of taxable income limitation. The CARES Act also allows taxpayers to use NOLs arising in 2018, 2019, and 2020 for carryback to the five years preceding the loss year, which may provide refund opportunities with amended returns.
- The CARES Act removed the limitation for non-corporate taxpayers with excess business losses over aggregate gross income, allowing deductions of up to $518,000 for joint filers or $259,000 for other filers. This provision applies to 2018, 2019, and 2020, so amended returns for 2018 and 2019 may be possible. Certain loss limitation rules on farming losses were also waived.
- Consider SECURE Act extensions of the family and medical leave credit and work opportunity credit, Families First Act credits for paid sick and childcare leave, and CARES Act credits for employee retention during the pandemic.
- Review payroll tax impact of relief actions. The IRS deferred payroll tax deposits for certain periods in 2020, but payment is required by year end. The CARES Act also allowed employers to delay payment of applicable employment taxes for certain periods in 2020 until December 31, 2021 (50% of the applicable amounts) and December 31, 2022 (remainder of applicable amounts). These provisions similarly apply to estimated self-employment taxes.
- Consider the § 199A deduction for non-corporate taxpayers of up to 20% of qualified business income from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate. For 2020, the deduction may be limited (with a phase-in for the limitation) if taxable income is over $326,600 for married couples filing jointly or $163,300 for other filers. These deduction limitations may apply depending on whether the taxpayer has a service-type trade or business such as law, accounting, health, or consulting, or whether the trade or business meets W-2 wage and qualified property (like machinery and equipment) requirements. Because there are taxable income thresholds and phaseouts for certain taxpayers, there may also be significant tax savings from deferring income or accelerating deductions into this year, depending on the taxpayer’s circumstances. Similarly, a taxpayer may be able to increase the deduction available by increasing W-2 wages or qualified property before year-end. This 20% qualified business income deduction requires taxpayers to navigate complicated rules and calculations, but it may provide a significant tax reduction for qualifying taxpayers.
- Consider making expenditures before year-end that qualify for the business property expensing option. For tax years beginning in 2020, the expensing limit is $1,040,000 and the investment ceiling is $2,590,000. This expensing is available for most depreciable property and off-the-shelf computer software. It also applies to qualified improvement property, which generally includes interior building improvements along with roofs, HVAC, fire protection, and alarm and security systems. Importantly, property acquired and placed in service before year-end is eligible for full expensing for the year.
- Consider 100% first-year bonus depreciation for new and some used machinery and equipment purchased and placed in service this year. Like expensing, bonus depreciation is available for the full year even if the asset was placed in service late in the year, so year-end purchases can receive a full first-year bonus write-off.
- Consider changing to the cash method of accounting, rather than the accrual method. “Small businesses” with less than $26 million of average annual gross receipts over a three-year period may be eligible for the cash method if they meet other requirements. The threshold was previously $5 million. Generally, the cash method of accounting allows more flexibility in timing income and deductions.
- Consider timing for a debt-cancellation event, including whether lower effective tax rates are expected this year or next year.
- Consider timing for disposition of a passive activity to allow a deduction for suspended losses to reduce current year taxable income.
- Review partnership and S corporation basis to make sure it is sufficient to deduct losses in current and future years.
- Review S corporation salaries to ensure that shareholders receive reasonable wages for their work for the business. The IRS often audits S corporations that pay all their profits as distributions without accounting for reasonable wages to shareholders.
- Consider setting up a retirement plan if there is not an existing plan.
Recent tax law changes and pandemic relief efforts require new considerations for year-end tax planning, and even more changes are likely in coming months. Many may be faced with unusual 2020 operating losses along with the challenge of ongoing pandemic and economic uncertainty – and a changing administration. Taxpayers will need to carefully consider all these issues in light of their specific circumstances and watch for continuing tax law changes as we close out this challenging year and move into 2021.
1 Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.