Timing Income and Deductions
Whether to defer or accelerate income and deductions to the extent possible is a perennial question. It is more complicated, now that Congress is debating the prospect of an increase in the top tax rate for individuals to 39.6% (up from 37%) as well as a 3% “millionaires’ surtax” (applicable for joint filers with income over $5 million, or 2.5 million for other individuals), a hike in the corporate tax rate to 26.5% (up from 21%), and an increase in the top rate on capital gains and qualified dividends to 25% (up from 20%). What’s more, the increase in the capital gains rate would apply to transactions after September 13, 2021. It has traditionally been the general thinking to defer income so that taxes are similarly deferred, while accelerating deductions to minimize taxes. That general thinking must be adapted to the proposed changes, as well as to each taxpayer’s situation.
Strategies for individuals.
For individuals with taxable income below the projected threshold for a 25% tax rate on transactions after September 13, 2021 ($450,000 for joint filers; $400,000 for singles), determine whether to realize profits before the end of the year. Factor in the ability to defer tax on capital gains by timely reinvesting the proceeds in a Qualified Opportunity Fund (QOF). For those likely to see capital gains taxed at no more than 15%, selling considerations usually apply; for all taxpayers, be sure than any year-end selling decisions put investment considerations above tax results.
Taking capital losses now can be used to offset capital gains; for applicable individuals, this can shield capital gains from the higher tax rate if enacted. For individuals, capital losses in excess of capital gains can offset up to $3,000 of ordinary income ($1,500 for married persons filing separately). Capital losses in excess of these limits can be carried forward indefinitely to offset gains (and limited ordinary income) in future years. But taxpayers should try to avoid the “wash sale rule” that bars a current write-off for losses if substantially identical securities are acquired within 30 days before or after the date of sale. Currently, the wash sale rule does not apply to cryptocurrency transactions; one proposal would extend the wash sale rule to cryptocurrency transactions, but not until 2022.
Strategies for businesses.
Businesses using the cash method of accounting have some flexibility in timing year-end income and expenses. For example, they can defer income by delaying billing for work completed near the end of the year so that payment will be received in 2022. They can also accelerate deductions by paying outstanding bills, stocking up on supplies, and paying out bonuses before the end of the year. Pass-through entities—sole proprietor-ships, partnerships, limited liability companies, S corporations—need to consider the impact that business decisions will have on owners’ taxes.
Businesses that need machinery and equipment should act now so that items can be placed in service before the end of the year. Then, when filing the 2021 return, they can decide on the best write-off option. It may be doing so immediately via first-year expensing, bonus depreciation, or a de minimis safe harbor rule. Or it may be spreading out deductions in coming years through regular depreciation.
Businesses maintaining inventory have several actions to consider before the end of the year. For slow-moving items, they can take a write-down for their costs if they offer them for sale now and keep proof of the reduced offering. They can raise cash by selling such items to a remainder or donating them to a charity for a deduction (in most cases, limited to the lower of basis or fair market value).
Selling a business, land, or other substantial property on the installment basis has traditionally been a good way to spread out tax over the period in which payments are received. Due to the prospect of higher taxes, however, sellers may want to report all of the gain in 2021, even though some payments are deferred. This is a complicated decision, and many factors come into play before electing out of installment reporting.
Taking Advantage of Expiring Provisions
It has become customary for Congress to extend expiring provisions late in the year, or even after the year has ended. Although many measures extended under ARPA and other legislation remain in effect for one or more years, some are ending at the end of 2021; whether Congress will extend them remains to be seen. Those who want to take advantage of them in case they are not extended should act soon. The following are some of the expiring provisions for individuals and businesses.
Tax professionals should keep their eyes on legislative developments in Congress.
Individuals who itemize their deductions in 2021 may elect to deduct cash contributions up to 100% of adjusted gross income (AGI); the limit is set to revert to 60% after 2021. Those who do not itemize may deduct up to $300, or $600 for joint filers [IRC section 62(a)(22)]. Cash donations can be made late in the year by charging them to a major credit card or mailing checks by December 31. C corporations can elect to deduct cash donations up to 25% of taxable income (instead of the usual 10%-of-taxable income limit). Businesses also have an enhanced deduction for food inventory through the end of the year. Whatever the donation, taxpayers must observe substantiation rules (e.g., receiving a written acknowledgment for gifts of $250 or more).
Gifts of appreciated securities held for more than one year result in a charitable contribution deduction based on their value; any appreciation escapes capital gains tax. Gifts of other property, such as land or a work of art, valued over $5,000 require a qualified appraisal. Taxpayers should not wait to get started on this; appraisers become extremely busy late in the year.
Those who work for companies with leave-based donation programs may want to take advantage of the opportunity to donate their unused leave time on a tax-free basis. Usually, such donations are treated as taxable compensation to the employee-donee, but for 2021 the donations are tax free (Notice 2021-42). The employer must donate the equivalent of the employees’ donations to a charity for COVID-19 relief before January 1, 2022; the employer gets the charitable contribution deductions.
Other expiring provisions.
These include, but are not limited to:
- Nonbusiness energy credit for certain home improvements (IRC section 25C)
- Credit for two-wheeled electric-powered vehicles (IRC section 30D)
- Credit for constructing energy efficient homes (IRC section 45L)
Taking Action for Retirement Plans
Required minimum distributions (RMD) for qualified retirement plans and IRAs, which were suspended for 2020, are effective for 2021. This means individuals who reached their starting date, as well as beneficiaries who need this income, should take RMDs before the end of the year. Individuals born after June 30, 1949, have a starting age of 72, which means someone born on August 1, 1949, must begin RMDs for 2021. They may defer the first RMD until April 1, 2022, but doing so means having to take two RMDs in the same year—one on April 1 and the second by December 31, 2022. The new RMD tables (https://bit.ly/3Dcvfiv), which reduce RMDs because of greater life expectancies factored into the tables, become effective in 2022, but the old tables apply to any 2021 RMD taken by April 1, 2022.
Individuals should consider converting a traditional IRA to a Roth IRA before the end of the year as a way to create future tax-free income. A conversion means recognizing income now. For seniors on Medicare, modified AGI in 2021 will determine whether and to what extent there is a surcharge on Part B and Part D premiums in 2023. Proposals now in Congress put limits on Roth IRA conversions for high-income taxpayers, but are not set to take effect until 2032.
Those who took qualified corona-virus distributions and loans in 2020 should take appropriate actions now. These include the following:
- Repaying loans from qualified retirement plans. This applies to qualified coronavirus loans as well as regular loans, the repayment of which was suspended for 2020.
- Reporting one-third of the 2020 distribution. (Unless it was reported in full on the 2020 return.) This income must be factored into withholding and estimated taxes for 2021 to avoid any estimated tax penalties.
- Repaying some or all of the qualified coronavirus distribution. There is a three-year window for repaying the 2020 distribution. The sooner the funds go back into the account, the greater the opportunity for tax-deferred income. Repayment will require filing an amended return for 2020 to back out the one-third or entire distribution, whichever is applicable, that was reported on that return.
Planning for Estates
The exemption amount for estates of decedents dying in 2021 is $11.7 million. This is also the same exemption amount for lifetime gifts. A proposal now under consideration in Congress would have the exemption amount revert to the pre-2018 level of $5 million as adjusted for inflation (which would be about $6 million in 2022) and increase the top estate and gift tax rate to 45% (up from the current 40%). These changes would apply after 2021. Thus, making transfers now may save transfer taxes in the long run.
Annual gift tax exclusion transfers.
Individuals may give cash and property up to $15,000 per donee in 2021 without any gift tax; gifts of future interests do not qualify for this annual gift tax exclusion. This exclusion may be used for as many donees as desired. For example, an individual with two adult children who are married, each of whom has three children, could give away $150,000 ($15,000 × 10 donees [2 children, their 2 spouses, and 6 grandchildren]). The exclusion can be doubled by spouses who consent to make split gifts. In the previous example, this would mean transfers of $300,000 could be made without any gift tax.
Transferring securities to someone with modest income who will pay no tax on long-term capital gains and qualified dividends is another strategy to consider. For example, giving appreciated securities to an elderly parent who is in a low tax bracket may enable a sale with no tax, leaving more after-tax income in the family. But transfers to children subject to the “kiddie tax” will not achieve tax savings if their investment income exceeds a threshold amount ($2,200 in 2021).
Gifts on behalf of a donee made directly to a medical service provider (e.g., doctor) or educational institution (e.g., college) have no dollar limits. Transfers may also be made to 529 plans using a special five-year rule. Gift-tax-free amounts are five times the annual limit, so that a contribution to a 529 plan up to $75,000 before the end of the year is not subject to gift tax.
Wealthy individuals may want to use their lifetime exemption amount for gifting now; it does not appear that there will be any clawback of the exemption if the limit is reduced as proposed. Such individuals may also want to review their charitable intentions. For example, they may use a charitable remainder trust to enjoy the income during their lifetime, with assets passing to the trust at death without any transfer tax cost.
Those with sizable estates should plan for liquidity, so the estate has sufficient funds to pay the estate tax (due nine months after the date of the decedent’s death). Life insurance planning may be helpful for this purpose.
Look for Ongoing Developments
Tax professionals should keep their eyes on legislative developments in Congress. Pending measures may impact actions to take before the end of the year in order to minimize taxes for 2021 as well as for 2022. If and when Congress finalizes any measure, tax planning may need to be updated. Advisors must also make sure that income tax withholding and estimated taxes for 2021 are sufficient to avoid penalties. Employees may ask employers to withhold additional taxes if needed to cover taxes resulting from year-end actions (e.g., taking capital gains, making Roth IRA conversions). The final estimated tax payment date for calendar-year C corporations is December 15, 2021; the final payment for individuals is due January 18, 2022. Individuals and businesses that work with tax advisors and planners should meet as soon as possible.