After a highly politically charged year, it is not a topic too many of us are excited to talk about; however, changes in administration, party lines, and the economy are giving rise to forward-looking tax planning considerations. The legislative changes are barely over for 2020, yet many of us are now looking towards the future, trying to advise our clients without a clear indication of the consequences of those decisions.
Here are three key considerations to review before making tax planning decisions:
- Entity structure changes are not black and white – making corporate election decisions is a precarious balance right now. Since the Tax Cuts and Jobs Act of 2017 have been in place, S Corporation elections had seemed to be the majority rule when it came to tax planning for small business owners. S elections gave small business owners the benefit of reduced self-employment taxes and the 20% qualified business income deduction bonus. With individual income tax rates creeping ever higher, though, the lower C Corporation tax rate of 21% is starting to look advantageous for taxpayers in top income tax brackets. But are corporate rates staying low? This is becoming a “worst-case scenario” analysis with many of our clients. If a current LLC or S Corporation makes an election to be treated as a C Corporation, they are stuck there for a minimum of 5 years. We know the rates are not changing for 2020, so late elections will have current tax rates applied, leaving 4 more years exposed to uncertainty. According to Joe Biden’s proposed tax plan, he wants to see the corporate income tax rate raised to 28%. That is still well below the current 35-37% tax applied to an individual in higher income tax brackets (over $200,000 in taxable income). However, his tax plan also calls for higher capital gains rates, which is important to consider in your C Corporation analysis since any income drawn by owners outside of payroll will be subject to double taxation as a dividend. My advice is to analyze this on a case-by-case basis with individual clients considering your client’s behavior. If a business owner is used to taking significant distributions in addition to their salary, you will need to carefully analyze the double taxation of a C Corporation before deciding if it is actually going to produce tax savings. I would suggest running the numbers for the 4 exposed years at the assumed higher rates so you can present your client with the “worst-case” vs. “best case” risk analysis before making a decision.
- What is the likelihood new bills will be passed – If you feel like you have whiplash trying to keep up with the week’s political climate and who is controlling what, you are not alone. As of right now, the Democrats will maintain control of the House for two more years, but by a razor-thin margin. The Senate majority hangs in the balance of Georgia’s special election in January, but it looks like it may stay Republican. So, what does this mean for our tax laws? I anticipate that there will be enough Democratic support, despite a Republican Senate, that bills are more likely than not to be passed that reflect what Joe Biden has already outlined in what he would like to see for tax law changes. Items I think you are most likely to see:
- Increases to corporate tax rates
- Increased child tax credits
- Increased taxation on global income for corporations with foreign investments
- Reduction in estate tax exemptions
- Return of credits for low to middle-income individuals such as a return of the first-time homebuyer credit
- Prioritizing taxpayer certainty and simplicity will be the focus on both sides as the economy recovers – the CARES Act passed early in 2020 has left an administrative headache that is still being untangled. The new administration will be tasked with the heavy burden of clarifying still murky guidance related to PPP loans, reconciling stimulus payments, and now new relief efforts passed to support the economy through the ongoing pandemic. Given the current complexity of the situation and the likelihood that the 2021 filing will be challenging for many, I think it is unlikely you will see significant tax law changes in the new administration’s first months. Both sides will be under pressure to answer existing outstanding questions about how the CARES Act stipulations as well as the new relief bill will ultimately be handled while concurrently tasked with trying to spur the economy forward. Notably, expenses paid for with PPP loan money will now be considered deductible after this week’s recent bill signing. Expect that forgiveness applications on previous loans will be taxpayer’s primary concerns before they start thinking about tax filings. Expect further that tax forms will be slow to get in preparers’ hands this season, especially considering the latest round of stimulus payments not being released until the end of the year.
They say the only guarantee in life is death and taxes. The safest tax planning bet right now is to understand that tax rates will not be going down based on our current political representation. Traditional tax planning for your clients like Roth IRA rollovers, accelerating capital gains, or even lifetime gifting now and into 2021 are probably good bets when looking at the ramifications of politics over the next 5 years. Happy tax planning!