In addition to saving income taxes for the current and future years, effective tax planning can reduce eventual estate taxes, maximize the number of funds you will have available for retirement, reduce the cost of financing your children’s education, and assist you in managing your cash flow to help you meet your financial objectives.
Tax planning strategies can defer some of your current year’s tax liability to a future year, thereby freeing up cash for investment, business, or personal use. This can be accomplished by timing when certain expenses are paid or controlling when income is recognized. Tax planning allows you to take advantage of tax rate differentials between years. However, if tax rates rise in a subsequent year, extra caution may be necessary.
New for 2020
Setting Every Community Up for Retirement Enhancement (“SECURE”) Act.
Repeals maximum age for traditional IRA contributions starting in 2020.
Contributions to traditional IRAs may be made if compensation is received.
The required minimum distribution (“RMD”) age increases from 70 to 72 beginning in 2020.
Partial elimination of stretch IRAs.
For participants or IRA owners whose death is after 2019, the distribution to a non-spousal beneficiary is required to be withdrawn from the plan within ten years following the plan owner’s death with certain exceptions.
Kiddie tax rules under the Tax Cuts and Jobs Act of 2017 (“TCJA”) were repealed.
The Coronavirus Aid, Relief, and Economic Security (“CARES”) Act resulted in changes including:
Suspension of the RMD in 2020.
10% Penalty for early distribution (under age 59½) waived for those who are diagnosed with COVID-19 (including spouse and dependents) or experiencing adverse financial consequences resulting from quarantine, furlough, lay-off, reduction of work, inability to work due to lack of child care, or owner or operation of business forced to reduce hours due to COVID-19.
Ability to spread COVID-19 related distributions from qualified retirement accounts over a 3-year period and the ability to repay the distributions within the 3-year period.
Changes to certain retirement plan loans apply to those impacted by COVID-19 (as described above).
Changes to deductible charitable contributions in 2020.
Tax Planning Goals: Proper tax planning can achieve the following goals
Reduce the current year’s tax liability.
Defer the current year’s tax liability to future years, thereby increasing the availability of cash for investment, business, or personal needs.
Reduce any potential future years’ tax liabilities.
Maximize the tax savings from allowable deductions.
Minimize the effect of the AMT on this year’s tax liability.
Maximize tax savings by taking advantage of available tax credits.
Maximize the amount of wealth that stays in your family.
Minimize capital gains tax.
Minimize the Medicare Contribution Tax on net investment income.
Avoid penalties for underpayment of estimated taxes.
Manage your cash flow by projecting when tax payments will be required.
Minimize potential future estate taxes to maximize the amount left to your beneficiaries and/or charities (rather than the government).
Maximize the amount of money you will have available to fund your children’s education as well as your retirement.
Year-End Tax Planning Tips
Timing when you pay deductible expenses and when you receive income (to the extent you have control) can reduce your taxes. Timing expenses and income can also defer some of your tax liability to next year (or even later years) giving you, rather than the government, use of your money.
There is some uncertainty as to what the 2021 tax rates will be given by the results of the presidential election. If you believe that the tax rates will rise in 2021, you may want to accelerate income and defer deductions.
Expenses You Can Prepay
Here are the most common deductible expenses you can easily prepay by December 31, if appropriate:
You can deduct charitable gifts of cash up to 60% of your AGI, tangible personal property, such as clothing and household goods, up to 50% of your AGI, and charitable gifts of appreciated capital gain properties up to 30% of your AGI. These percentages apply to gifts made to public charities.
The CARES Act temporarily suspended the 60% AGI limitation for 2020 on qualifying cash donations to public charities and private operating foundations, allowing individuals who itemize to take a charitable contribution deduction for up to 100% of their AGI. Donations that do not qualify are those made to donor-advised funds or charities whose exempt purpose is to support other charities. Grant-making private foundations are also excluded.
State and Local Income Taxes and Property Taxes
A taxpayer may claim an itemized deduction of up to $10,000 ($5,000 for married filing separately) for the aggregate of (1) state and local income taxes and (2) state and local property taxes paid.
Miscellaneous Itemized Deductions
All miscellaneous itemized deductions that are subject to the limitation of 2% of AGI will be suspended until years beginning after December 31, 2025.
Before the end of the year, consider prepaying your mortgage payment for next January in the current year in order to accelerate the deduction.
Before the end of the year, be sure to pay any margin interest before December 31, since interest accrued at year-end is only deductible if actually paid. This may also reduce the Medicare Contribution Tax on net investment income.
Before the end of the year, accelerate the purchases of business equipment to take advantage of expensing allowances, subject to certain limitations. To qualify, the property must be placed in service in the year of the intended deduction.
Income You Can Accelerate or Defer
Timing income can be more difficult than timing deductions, but here are some types of income that you may be able to control the timing of receipt so you can gain the advantage of having the income taxed in a year that you are in a lower tax bracket.
Cash Salaries or Bonuses
If you anticipate your current year’s income tax rate to be lower than next year’s rate, you can accelerate salary or bonuses into the current year. You would need to determine if there are strict limitations on amounts that can be accelerated. However, if next year’s rate is lower than your current year’s rate, it may make sense to defer such income until next year provided the income is not constructively received (made available to you in the current year).
Consulting or Other Self-Employment Income
If you are a cash-basis business and you anticipate your current year’s tax rate to be lower than next year’s rate, you can accelerate income into the current year. Otherwise, you would want to defer such income.
Retirement Plan Distributions
If you are over age 59½ and your tax rate is low this year, you may consider taking a taxable distribution from your retirement plan even if it is not required or consider a Roth IRA conversion.
Individuals of at least age 70½ can make tax-free distributions of up to $100,000 from individual retirement accounts directly to public charities. This strategy allows an individual to exclude the distribution from income “above the line”.
The CARES ACT waived the required minimum distributions during 2020 for IRAs and retirement plans, including for the beneficiaries who inherited such accounts. This waiver includes RMDs for those who turned 70½ in 2019 and took their first RMD in 2020. The CARES Act also waived the 10% early-withdrawal penalty on retirement account distribution for individuals facing virus-related challenges.
The SECURE Act, which was signed into law on December 20, 2019, changed the timing by which you must withdraw your first RMD. If your 70th birthday is July 1, 2019, or later, you are not required to take the first distribution from the retirement accounts until you reach age 72.
The following ideas can lower your taxes this year:
If you have unrealized net short-term capital gains, consider selling the positions and realize the gains in the current year if you expect next year’s tax rate to be higher. Only consider this strategy if you do not otherwise intend to hold the position for more than 12 months, making it eligible for the long-term capital gain rate of 20%, exclusive of the additional Medicare Contribution Tax. However, you may be able to apply the netting rule which may result in the offsetting of long-term losses to short-term gains, resulting in a tax savings of 37% in 2020 rather than 20%.
Considering investing in a qualified opportunity fund.
Review your portfolio to determine if you have any securities that you may be able to claim as worthless, thereby giving you a capital loss before the end of the year. A similar rule applies to bad debts.
Avoid wash sales. Loss recognition is disallowed if the same or substantially identical security is purchased 30 days before or after the sale of the security that created the loss.
Consider a bond swap to realize losses in your bond portfolio. This swap allows you to purchase similar bonds and avoid the wash sale rule while maintaining your overall bond positions.
Similarly, you may consider selling securities this year to realize long-term capital gains that may be taxed at the more favorable rate this year, and then buying them back to effectively gain a step-up in basis. Since the sales are at a gain, the wash sale rules do not apply.
Real Estate and Other Non-Publicly Traded Property Sales
If you are selling real estate or other non-publicly traded property at a gain, you would normally structure the terms of the arrangement so that most of the payments would be due next year. You can use the installment sale method to report the income. This would allow you to recognize only a portion of the taxable gain in the current year to the extent of the payments you received, thereby allowing you to defer much of that tax to future years.
U.S. Treasury Bill Income
If you have U.S. Treasury Bills maturing early next year, you may want to sell these bills to recognize income in the current year if you expect to be in a lower tax bracket this year than next year.
As a result of the Further Consolidated Appropriations Act, the 7.5% of AGI threshold has been retained for 2019 and 2020. Thereafter, the threshold will revert to 10% of AGI. Therefore, bunching unreimbursed medical expenses into a single year could result in a tax benefit. Medical expenses include health insurance and dental care. If you are paying a private nurse or a nursing home for a parent or other relative, you can take these expenses on your tax return even if you do not claim the parent or relative as your dependent, assuming you meet certain eligibility requirements.
As a result of the TCJA, many itemized deductions have been eliminated or limited. The deduction for the charitable contribution is the exception, as it has virtually been untouched by the new law. At the same time, the standard deduction has increased substantially. An individual can deduct the larger of either his/her standard deduction or itemized deductions. Thus, in order to maximize the deduction for charitable contributions, it might be best to bunch gifts to charities in one year, so the individual’s charitable contributions exceed the standard deduction amounts, and he will be able to itemize. Similarly, funding a donor-advised fund, private foundation or charitable trust in a particular year may be effective in maximizing the tax benefit of such charitable deductions.
Utilize Business Losses or Take Tax-Free Distributions
It may be possible to deduct losses that would otherwise be limited by your tax basis or the “at-risk” rules. Or, you may be able to take tax-free distributions from a partnership, limited liability company (“LLC”), or S corporation if you have a tax basis in the entity and have already been taxed on the income. If there is a basic limitation, consider contributing capital to the entity or making a loan under certain conditions.
If you have passive losses from a business in which you do not materially participate that are in excess of your income from these types of activities, consider disposing of the activity. The tax savings can be significant since all losses become deductible when you dispose of the activity. Even if there is a gain on the disposition, you can receive the benefit of having the long-term capital gain taxed at 23.8% (28.8% if the gain is subject to depreciation recapture) inclusive of the Medicare Contribution Tax with all the previously suspended losses offsetting ordinary income at a potential tax benefit of 40.8% in 2020 inclusive of the Medicare Contribution Tax.
Incentive Stock Options
Review your incentive stock option plans (“ISOs”) prior to year-end. A poorly timed exercise of ISOs can be very costly since the spread between the fair market value of the stock and your exercise price is a tax preference item for AMT purposes. If you are in the AMT, you will have to pay a tax on that spread, generally at 28%. If you expect to be in the AMT this year but do not project to be next year, you should defer the exercise.
Conversely, if you are not in the AMT this year, you should consider accelerating the exercise of the options; however, keep in mind to not exercise so much as to be subject to the AMT.
If you have not already done so, consider making your annual exclusion gifts to your beneficiaries before the end of the year. You can make tax-free gifts of up to $15,000 per year, per individual ($30,000 if you are married and use a gift-splitting election, or $15,000 from each spouse if the gift is funded from his and her own separate accounts). By making these gifts, you can transfer substantial amounts out of your estate without using any of your basic exclusion amounts (“BEA”). Also, try to make these gifts early in the year to transfer that year’s appreciation out of your estate.
Furthermore, because of the increased cumulative BEA in 2020, you may wish to make additional gifts to fully utilize such exclusion of $11.58 million ($23.16 million for married couples). The BEA has doubled as a result of the TCJA; however, it will sunset at the end of 2025 reverting back to the maximum BEA in effect before the TCJA became law. The 2021 BEA is set at $11.70 million ($23.40 million for married couples). It is possible that there could be a tax bill in 2021 that reduces the BEA especially as a result of the 2020 presidential election. When combined with other estate and gift planning techniques such as a grantor retained annuity trust, tax planning strategies may enable you to avoid estate and gift taxes and transfer a great deal of wealth to other family members (who may be in a lower income tax bracket or may need financial assistance).
Tax Strategies for Business Owners
Timing of Income and Deductions
If you are a cash-basis business and expect your current year’s tax rate to be higher than next year’s rate, you can delay billing until January of next year for services already performed in order to take advantage of the lower tax rate next year. Similarly, even if you expect next year’s rate to be the same as this year’s rate, you should still delay billing until after year-end to defer the tax to next year. You also have the option to prepay or defer paying business expenses in order to realize the deduction in the year that you expect to be subject to the higher tax rate. This can be particularly significant if you are considering purchasing (and placing in service) business equipment. If you are concerned about your cash flow and want to accelerate your deductions, you can charge the purchases on the company’s credit card. This will allow you to take the deduction in the current year when the charge is made, even though you may not actually pay the outstanding credit card bill until after December 31.
Tax benefits are available for an immediate deduction of business equipment purchased and placed in service in 2020. The amount allowable for full deduction in 2020 under IRC Sec. 179 is $1,040,000 ($1,050,000 in 2021) if property placed in service does not exceed $2,590,000 ($2,620,000 in 2021). After reaching this threshold the deduction is phased out dollar-for-dollar, up to $3,630,000 ($3,670,000 in 2021). Bonus depreciation was increased to 100% for property placed in service after September 27, 2017. The allowable bonus percentage decreases by 20% each year, beginning in 2023 with 2026 being the last year at 20% bonus. The TCJA expands the definition of qualified property to include used property (as long as the taxpayer did not use the property prior to the purchase).
Note: Under the TCJA, some businesses may not be eligible for the bonus depreciation. For example, bonus depreciation is not allowed for businesses with annual gross receipts of more than $25 million for the prior three years and real estate businesses that elect to deduct 100% of their business interest expenses.
Note: The bonus depreciation is an add back on most state returns while IRC Sec. 179 expense is only a partial add back.
Note: Some states may not allow bonus depreciation.
If you have debt that can be traced to your business expenditures – including debt used to finance the capital requirements of a partnership, S corporation, or LLC involved in a trade or business in which you materially participate – you can deduct the interest “above-the-line” as business interest rather than as an itemized deduction. The interest is a direct reduction of the income from the business. This allows you to deduct all your business interests, even if you are a resident of a state that limits or disallows all your itemized deductions.
Business interest also includes finance charges on items that you purchase for your business (as an owner) using the company’s credit card. These purchases are treated as additional loans to the business, subject to tracing rules that allow you to deduct the portion of the finance charges that relate to the business items purchased. Credit card purchases made before year-end and paid for in the following year are allowable deductions in the current year for cash-basis businesses.
Note: Interest expense deduction is limited to 30% of adjusted taxable income (“ATI”). Such limitation does not apply to businesses with average gross receipts that do not exceed $25 million, and those electing real property trade or business.
Note: The enactment of the CARES Act temporarily increased the 30% limitation to 50% for tax years 2019 and 2020.
Qualified Business Income Deduction
Qualified business income (“QBI”) is generally defined as net income and deductions that are effectively connected to a U.S. business. Through 2025, the TCJA provides an IRC Sec. 199A deduction for sole proprietors and owners of pass-through entities of a “qualified” business generally equal to 20% of qualified business income, subject to various loss and deduction limitations. Though this deduction is not allowed in calculating the owner’s AGI, it does reduce the taxable income.
Excess Business Losses and Net Operating Losses
Excess losses from all your trades or businesses are limited to $510,000 (married filing jointly) and $255,000 (all others). Any losses above these amounts will be carried forward as a net operating loss (“NOL”).
Beginning in tax years after December 31, 2017, NOLs can no longer be carried back. NOLs can be used to offset 80% of taxable income in future years with any excess to be carried forward indefinitely.
Note: The CARES ACT removed the limitation on excess business losses for taxpayers other than corporations for tax years beginning after December 31, 2017, and before January 2, 2021. It modified the loss limitation for non-corporate taxpayers so they can deduct excess business losses arising in 2018, 2019, and 2020. In the event such losses were not fully utilized in the year it arose, the CARES Act allows non-corporate taxpayers to carry back such losses five years unless an election is made to forego the carryback. The NOL limitation of 80% of taxable income has also been temporarily suspended. All limitations related to EBL and NOL will resume for years beginning after 2020 and before 2026.