Year-end planning for Americans will be more challenging than ever in 2020, as we are forced to make year-end financial decisions based on events that will not happen until 2021. Two Georgia Senate runoff elections will be held on January 5, 2021, which will determine whether Republicans retain control of the Senate or whether Democrats will have control of the White House and both Houses of Congress.
Legislation is always unpredictable, and so are the effective dates that new legislation takes effect. However, we do know what both parties have been championing with respect to taxes and have historical precedent for guidance.
Should Democrats win both Senate seats, they would be able to act unilaterally for the first time since 2010, setting the stage for major tax increases on businesses and high-income, high-net worth households. Should this occur and increases are enacted retroactive to January 1, 2021, numerous income acceleration and estate planning gifting strategies should be deployed before 2020 year-end.
However, if the Republicans win one of the two runoffs and retain control of the Senate, legislative gridlock will likely prevail for another two years, lessening the need for planning in 2020. Regardless, some bipartisan policy agreement is expected in a number of areas such as whether to extend certain CARES Act relief provisions that expire at the end of 2020.
PLANNING FOR A DEMOCRAT-CONTROLLED CONGRESS
Higher Income Tax Rates
During the 2020 election campaign, Democrats proposed to raise taxes on earners with more than $400,000 of annual income, cut them for others, and raise benefits for the lowest earners. Those affected would want to deploy basic tax bracket management strategies for times of rising tax rates, such as to accelerate income into 2020 by converting traditional IRAs to Roth IRAs, exercising stock options and taking bonuses early if possible.
From a corporate rate perspective, Biden’s proposal is to increase the corporate tax rate, bumping it from 21 percent to 28 percent. Biden would also create a new alternative minimum tax of 15 percent on corporations with over $100 million in book net income. Biden’s plan would increase the tax on foreign profits, doubling the tax rate on global intangible low-taxed income from 10.5 percent to 21 percent for companies operating in the U.S. and abroad. Facing potentially rising tax rates and a new corporate alternative minimum tax, corporations should consider income acceleration techniques as well.
Limits on Itemized Deductions
A Biden administration would also limit the value of itemized deductions. Under the Biden proposal, a tax deduction would save a taxpayer with more than $400,000 of income no more than 28 cents on the dollar, even if that person’s top tax bracket is higher. In addition, itemized deductions for those with income over $400,000 would be further limited by restoring the pre-2018 Pease Limitation. This would reduce itemized deductions by 3 percent of AGI over the threshold – up to 80 percent of itemized deductions. Restoring the Pease Limitation would cause many current itemizers to fall below the standard itemized deduction limit of $24,800 for a married couple in 2020, impacting their charitable contribution, mortgage interest and state and local tax (SALT) decisions.
Affected taxpayers should consider accelerated deductions into 2020, especially large charitable donations, to take advantage of increased limits currently in place as part of the CARES Act. However, if Biden restores the SALT deduction for amounts above the current $10,000 cap, itemizers should plan to defer payments of these taxes until after the law change. Taxpayers should be cautioned that the potential benefit of this SALT deduction deferral could be reduced or offset by the 28 percent top rate benefit ceiling and a restoration of the 3 percent Pease Limitation.
Increased Payroll Taxes
The Biden payroll tax proposal would subject wage and self-employment income in excess of $400,000 to the Social Security payroll tax. Currently, the 6.2% tax is on the first $137,700 of wage income, so wages and earnings between $137,700 and $400,000 would not be taxed, creating a donut-hole structure. Should this Social Security tax be expanded, business owners can consider converting to an S corporation structure, as S corporation dividends are not subject to employment taxes. Assuming that reasonable compensation rules are met, this would be a viable solution to this potential payroll tax increase. As for executive compensation, incentive stock options would likely become more popular because there is no Social Security tax on the option spread.
Higher Capital Gains and Investment Income Taxes
Under a Biden capital gains and investment income plan, individuals earning over $1 million would be subject to ordinary income tax rates on their long-term capital gains and qualified dividends. Should both Georgia Senate seats be won by Democrats, investors with incomes over $1 million should seriously consider selling appreciated assets in 2020 as the the 20 percent preferential rate for long-term capital gains and qualified dividends would very likely be eliminated. Conversely, any capital loss harvesting – a year-end ritual in any other year – should be delayed until 2021 as capital gains rates would be expected to go up.
Other effective capital gains tax mitigation strategies to contemplate before 2020 year-end under this scenario include gifting appreciated assets to utilize the current estate and gift tax exemption, and charitable contributions of appreciated assets to qualified charities, including donor-advised funds and private foundations.
Limit on the 199A Pass-Through Deduction
The Biden platform would retain the 199A qualified business income deduction for pass-through business income, however he proposes modifications to rules utilized by real estate investors and a phase-out of the deduction for taxpayers with income exceeding $400,000. Again, affected business owners are encouraged to consider accelerating income into 2020 should Democratic Senate control appear likely.
Estate and Gift Tax Changes
Biden’s estate tax proposals are his most dramatic proposed changes. The current estate tax exemption threshold is $11.58 million per individual (indexed for inflation) with a top tax rate of 40 percent. After 2025, this amount is scheduled to revert to the pre-Tax Cuts and Jobs Act (TCJA) exemption, which is an indexed amount that would equate to approximately $5.8 million. The Biden plan would accelerate the reduction of the lifetime exemption threshold either to the pre-TCJA level of $5 million (indexed for inflation), or as low as the 2009 level of $3.5 million per individual as proposed by the Obama administration. The tax on estates above this threshold would increase as well to 45 percent.
Another significant Biden proposed change is with regard to the “basis step-up” at death. Currently, a future capital gains tax upon disposition of an inherited asset is based on its value at the time it is inherited, rather than the time of purchase – referred to as the “basis step-up”. The Biden plan is unclear as to how this would be implemented, but there are two options. The first is to tax unrealized gains of the decedent, whereby the decedent’s estate would pay the tax at death, and presumably the heirs would take the assets at a basis stepped-up to fair market value. Alternatively, the heirs would receive carryover basis at death, and would pay capital gains tax on the sale of the asset based on the value at the time the original investment. Either option would lead to a significantly higher income tax liability for appreciated assets.
Regardless of the option chosen for this proposal, it would create significant practical problems with establishing the tax basis of long-held assets such as appreciated investments or a family business. Combined with the possibility that the estate tax exemption could be cut in half or more, taxpayers with estates worth in excess of several million dollars and with significantly appreciated assets should seriously consider a wealth-transfer plan prior to year-end.
Retirement Plan Contributions
Democratic Senate control would also likely change how retirement contributions are treated for tax purposes. Biden proposes to convert currently deductible retirement plan contributions into a refundable 26 percent tax credit for each $1 contributed. Roth tax treatment would be unaffected and therefore, higher income taxpayers would likely benefit from a shift to more Roth-style accounts.
PLANNING FOR A REPUBLICAN-CONTROLLED SENATE
A continued split of government control would prevent President-elect Biden from getting many of his tax proposals enacted into law. That said, as the pandemic continues to impact businesses and taxpayers across the country, it is likely that additional legislation will be enacted to provide economic relief.
Among the more likely developments are an infrastructure bill and further relief packages such as have been enacted under the CARES Act. Prior packages included direct tax rebate payments to individual taxpayers, the acceleration of depreciation deductions for qualified improvement property, increased business interest expense deductions, increased charitable contribution deductions, and restoration of net operating loss carrybacks. New payroll tax programs were also created, including the employee retention credit, additional credits for paid sick leave and paid family leave, and the deferral of the employer portion of payroll taxes.
Extender provisions are also likely to get bipartisan support. Provisions in the TCJA, which generally are set to expire at the end of 2025, could be extended such as the middle-class tax cuts, and research and development expensing which is currently set to sunset in January 2022. With over 30 provisions expiring at the end of 2020, it is reasonable to expect that bipartisan support exists to extend provisions of the CARES Act which provided relief for taxpayers, including retirement income provisions.
Should a Republican-controlled Senate in 2021 appear likely, there are several year-end planning strategies to consider.
Income Tax Planning
Traditional year-end tax planning in a normal year would include postponing income into the following year combined with accelerating deductions into the current year. With the current TCJA higher itemized standard deduction amounts, a bunching strategy for itemized deductions may be effective. A taxpayer would take the standard deduction every other year and bunch itemized deductions such as charitable contributions or perhaps medical deductions into the itemized off year. This year may be a good year to bunch itemized deductions with higher limits on charitable contributions and a lower 7.5 percent threshold for medical expenses only available for 2020.
Capital Gains and Losses
Investors with less concern about a capital gain rate increase in 2021 may be able to focus on the usual year-end strategy of looking over their investment portfolio for holdings they might wish to sell and see how their capital gains and losses for the year match up in deciding whether to do the sale in 2020 or 2021. Recognizing capital losses to offset recognized capital gains, referred to as “loss harvesting,” is important to consider at year-end. However, as noted above, for investors that believe capital gains tax rates may be higher in 2021 than they are now, the recognition of losses should be deferred until January, while long-term capital gains should be recognized this year. The 30-day wash sales rule for losses must be taken into account if sold securities are to be repurchased within a short timeframe.
Charitable giving remains a key strategy to reduce income tax for taxpayers electing to itemize their deductions. For those that do not itemize, under the CARES Act for 2020, a $300 charitable cash contribution can be made directly to a charity to receive an “above-the-line” deduction. In addition, those over age 70½, can make qualified charitable contributions (QCD) from traditional IRAs of up to $100,000 despite the waiver of a required minimum distribution (RMD) for 2020 under the CARES Act. Making a QCD before year-end, reduces the value of an IRA, which in turn reduces the amount of the 2021 RMD. Note that QCDs cannot be made to donor-advised funds or most private foundations.
Another strategy for the charitably inclined to consider is donation of appreciated securities held for more than one year. While this has long been a tax-advantaged way to make charitable gifts, the CARES Act enhances the tax benefit by allowing up to 100% of AGI to be deducted. Note that this enhanced deduction limit is not available for gifts to donor-advised funds or supporting organizations, which are still limited to 60% of AGI for cash gifts and 30% of AGI for appreciated securities.
Finally, taxpayers that are itemizing this year but may not be in future years, should consider “gift bunching” by accelerating potential charitable gifts in 2021 or later years to 2020. If the amounts to be gifted are not ready to pass to charities immediately, consider contributing to a donor-advised fund, which may allow you to receive the current-year tax deduction while retaining the ability to request that the donated funds be distributed to qualified charities during future years.
Retirement Planning and Roth Conversions
In the event of a Republican-controlled Senate in 2021, any increases in tax rates that are passed are much less likely to be made retroactive. As a result, there would be reduced benefit in Roth IRA conversions this year. Of course each taxpayer’s situation is different, and a taxpayer in a 24% or lower tax bracket should definitely consider whether a Roth conversion makes sense. Retirement planning should continue to focus on changes to the new distribution rules for IRA beneficiaries and the ability to continue to make IRA contributions after age 70 ½ if there is enough earned income to support them.
Health and Education Savings
Year-end planning for those with a high-deductible health plan should always include consideration for contributions to a health savings account (HSA). Taxpayers with self-only coverage can deduct up to $3,550 ($7,100 with family coverage) for 2020. An additional $1,000 contribution is permitted if the eligible taxpayer is at least age 55. Some call this a turbo-charged IRA because it offers three tax savings benefits: first, contributions are currently tax deductible; second, the earnings compound tax-free; and third, withdrawals are tax-free when the money is withdrawn for medical expenses. After age 65, withdrawals can be used for non-medical expenses as well. Consider HSAs as a form of long-term care insurance, which grow tax free for use during retirement.
A 529 plan or Coverdell education savings account should also be considered to help ease the burden of future qualified higher education expenses. Any investment growth is federally income tax-free to the extent distributions do not exceed qualified expenses, and many states offer income tax benefits for qualifying contributions. Keep in mind, taxpayers also can use 529 plan distributions to pay up to $10,000 of elementary or secondary school expenses per student per year.
Annual Gift Giving
An individual can give up to $15,000 to as many individuals as he or she chooses without utilizing any of his or her lifetime gift and estate tax exemption amount (currently $11.58 million.) That $15,000 combines to $30,000 for married couples who either make separate gifts or choose to “gift split.”
Contributions to a family member’s Section 529 Plan for education can be made with annual exclusion gifts. In fact, a 529 Plan can be front loaded with the gift spread ratably over a five-year period when the gift tax return is filed. This enables a married couple choosing to “gift split”, is able to gift up to $150,000 tax-free to a 529 Plan.
In addition to the annual exclusion gifts noted above, an individual can also pay tuition expenses and qualified medical expenses directly to the provider without creating a taxable gift. Tuition includes the cost of education from preschool through graduate school, but does not include non-tuition charges such as room and board or books. Qualified medical expenses include health insurance premiums.
Wealth Transfer Planning
Finally, under a Republican-controlled Senate, estate and gift planning may be less a 2020 year-end priority given the reduced risk of a reduction in the unified credit or an increase in estate and gift tax rates in 2021. However, the increased estate tax lifetime exemption which sunsets in five years presents an extraordinary opportunity to effectively transfer wealth tax-free. The current $11.58 million lifetime gift and estate tax exemption is scheduled to sunset on December 31, 2025, at which time it will likely be reduced by at least by half, indexed for inflation. Given this reduction is almost certain to occur, a wealth-transfer plan should be developed now, so that you can permanently take advantage of this higher exemption amount.
2020’s year-end tax and financial planning is unique. It will require consideration of the taxpayer’s facts and circumstances, existing rules, predicted election results in Georgia, and the potential of resulting retroactive tax legislation advancing in 2021. Based on analysis of these factors, each taxpayer will have to decide whether to complete any special planning actions before the end of 2020. Not to be forgotten however, are normal year-end planning strategies that should be deployed regardless of the outcome of the Georgia runoffs.
AAA-CPA member Daniel F. Rahill, CPA, JD, LL.M., CGMA, is a managing director at Wintrust Wealth Services. He is also a former chair of the Illinois CPA Society Board of Directors.
This information may answer some questions, but is not intended to be a comprehensive analysis of the topic. In addition, such information should not be relied upon as the only source of information; professional tax and legal advice should always be obtained.
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