While all of us are busy during the holiday season, tax professionals’ heads are spinning more than usual on how best to approach year end planning. With the 2021 calendar year ending in less than 30 days, coupled with tax legislation that could (or could not) be enacted, a myriad of options exist when trying to position businesses and their owners to optimize cash. To try to make the planning a little less foggy, it will be important to evaluate the existing federal tax law while still considering the significant changes under the proposed Build Back Better Plan. Either way, the approved tax law changes for 2021 and pending tax law changes for 2022 are poised to cause most individuals to send more cash to the federal government.
1.Deferred 2020 Employer Social Security Payments are Due: It has been so long ago that businesses may have forgotten that they deferred their employer portion of social security in 2020. As part of the CARES act, employers were permitted to defer deposits of the employer portion of Social Security due between March 27, 2020 through December 31, 2020. However, the law only provided a deferral, and half of the deferred payment is due as of December 31, 2021, with the other half coming due on December 31, 2022.
The IRS has taken recent action to inform the public that they will not tolerate late payments on the deferral. The payment of 50% of the deferral is due regardless of whether a business received an IRS notice requesting payment. It’s clear through the issuance of OTMA 2021-07 that the IRS expects to enforce stiff penalties if the December 31st deadline is missed. The IRS memorandum states that if any portion of the deposit is not made by the applicable date, whether December 31, 2021 or December 31, 2022, the deferral will be deemed completely invalid and all penalties will be assessed using the original due date for the employer portion of Social Security.
It will be important to ensure that businesses have cash to make these payments, but that they also have properly communicated with their payroll providers to submit the amounts due in a timely manner. Any such request to the payroll company to ensure payment should be in the form of written communication. Lastly, the amount paid should be clearly communicated to your tax advisor so it can be properly recorded on the business tax return.
2.Employee Retention Credit: Many businesses were shocked and disappointed to learn that the Infrastructure Bill eliminated the ability to claim the 2021 fourth quarter employee retention credit. Even worse, some businesses were claiming the ERC in the start of the fourth quarter as the change in law wasn’t passed until November 15th. Notice 2021-65 was issued by the IRS in early December and details the alternatives businesses can consider in order to avoid penalties for claiming the ERC in the fourth quarter.
If an employer reduced their federal payroll deposits in relation to the expectation of the fourth quarter employee retention credit, they must deposit those taxes on or before December 20, 2021 in order to receive penalty relief.
Alternatively, if an employer claimed an advance payment for the ERC in the fourth quarter, Notice 2021-65 offers penalty relief provided the employers who received such advanced payments repay the payroll taxes by the due date of their applicable employment tax return that includes the fourth quarter of 2021. Generally, the fourth quarter Form 941 is due no later than January 31, 2022.
Significant penalties can be assessed if employment taxes are not paid on time. Therefore, it will be important for businesses to understand the amount that is owed to the federal government in relation to any 2021 fourth quarter ERC claimed and ensure timely payment. In addition, any other employee retention credits claimed throughout the 2021 tax year should be reported to your tax advisor to ensure the proper reduction to salaries and wages on the 2021 federal business tax return.
3. Net Operating Rules: Think that generating a net operating loss carryforward in 2020 means you won’t have to pay any cash taxes in 2021? Not so fast. As a result of lost business due to the pandemic, PPP debt forgiveness not being taxable, and PPP expenses being deductible, net operating losses were prominent in 2020. However, the rules surrounding how the net operating loss can be utilized has changed for the 2021 taxable year.
Any net operating loss generated in 2018, 2019, or 2020 that is being carried forward into the 2021 taxable year will be limited to 80% of taxable income. However, net operating losses being carried forward from before 2018 will not be limited when offsetting taxable income.
For example, assume a business has taxable income of $60,0000 for the 2021 calendar year. The business generated a net operating loss carryforward of $50,000 from 2017, and a net operating loss carryforward of 75,000 from 2020. Even though the 2017 net operating loss is allowed to offset the full amount of taxable income, the remaining net operating loss carryforward from 2020 will be limited to 80% of the taxable income remaining, or $8,000 (60,000-50,000 x 80%).
As a result of the legislation, some type of cash payment will have to be made to the IRS as the net operating loss carryforwards are limited to 80% of taxable income. The limitations on net operating losses could also result in additional state income tax payments having to be made.
Build Back Better Plan Interplay: The current bill passed by the House does not have any changes being made to federal net operating losses. In other words, the 80% limitation is here to stay. Planning opportunities would include working with your tax advisors to match expenses closely with taxable income streams.
An important proposal buried in the Build Back Better Plan is that net operating losses will no longer be allowed to offset net investment income tax of 3.8%. With the proposed expansion of the net investment income tax to include trade or business income, taxpayers with a net operating loss may be very surprised that the net investment income tax is still being assessed. Take the following example:
NIIT Expansion & NOL Example
The Bonadio Group
The example illustrates the impact of the expansion of the net investment income tax to S Corporation ordinary income and not being able to utilize a net operating loss before applying the net investment income tax under the Build Back Better Plan. In this example, the taxpayer would see a significant impact on cash taxes due between the current legislation and proposed legislation.
4. Excess Business Loss Limitation Rules Are Back With a Vengeance: Many might have forgotten about the TCJA law that limited the ability to deduct business losses at the individual level. The new law was originally enacted as part of the TCJA and was supposed to apply to the 2018, 2019, and 2020 taxable years but was quickly lifted as part of the CARES Act pandemic assistance program. The ability to deduct all businesses losses, with no limitation for taxable years between 2018 through 2020, allowed taxpayers to create net operating losses and potentially carry them back five years or carry them forward indefinitely. The deferral of the excess business loss rules, coupled with modified net operating loss rules, provided taxpayers with a great cash benefit during the pandemic (even if we are still waiting to receive the refunds from the IRS).
However, for the 2021 taxable year the excess business loss limitation rule not only applies but a technical correction related to the rule might cause some taxpayers to generate more taxable income than expected. In general, the excess business loss limitation rule requires a taxpayer to total all their business income and losses, including their Schedule C and pass-through entity income and losses, and limits the ability to deduct losses in excess of $524,000 if married filing joint ($262,000 if single) for the 2021 taxable year. To be clear, even if you have generated $2,524,000 of net business loss for the year, only $524,000 will be allowed as a deduction. The remaining $2,000,000 is treated as a net operating loss for the taxable year, with an indefinite carryforward, and only will offset 80% of taxable income going forward.
If that isn’t bad enough, the technical correction provided in the CARES Act clarified that W-2 wages cannot be included when totaling your business losses. Adding to the pervious example, if a taxpayer’s spouse makes $750,000 in W-2 wages, and the total business loss was $2,524,000, many were taking the position that the wages of $750,000 would be included when evaluating the overall business loss. In other words, prior to the technical correction, the business loss subject to the limitation in our example would be $1,774,000 (2,524,000-750,000), the limitation would be $524,000, and a net operating loss carryforward of $1,220,000 would be generated. As a result, no taxable income would remain.
Unfortunately, Congress felt otherwise. Instead, the technical correction is explicit that the wages are not allowed to offset business losses. The taxpayer would reflect $750,000 of wage income, be limited to $524,000 of business losses, and create taxable income of $226,000. Don’t bother rereading, you are correct! Even though the taxpayer generated $2,524,000 of business losses, which is much greater than their overall income, they would have taxable income. The net operating loss carryforward to the 2022 taxable year would be $2,000,000 (2,524,000-524,000).
It’s the beginning of December, how could we possibly combat this issue? For S Corporation shareholders, who are required to pay reasonable compensation, this could develop into a taxable income situation quickly. Make sure to review the reasonable compensation arrangement for 2021 and going forward.
An alternative planning strategy to limit the amount of excess business loss limitation, would be to defer business expenses into the 2022 taxable year, as opposed to 2021. For example, consider the timing of the bonus pay outs. Alternatively, are there income items that could be escalated into 2021? For example, including advanced payments all in the year received, with no deferral. Also, explore method of accounting changes with your tax advisor. Depending on the methods used, there may be a way to better manage taxable income. The best part about an automatic change in method of accounting – they don’t have to be completed until the extended due date of the tax return.
Build Back Better Plan Interplay: Under the existing law the excess business loss limitation rules no longer apply to taxable years beginning after December 31, 2027. The Build Back Better Plan would make the loss limitation permanent.
As noted earlier, the expansion of the net investment income tax to include trade or business income in 2022, could be subjecting a variety of pass-through entity business owners to an additional 3.8% tax. For example, S Corporation shareholders filing a married filing joint return with an AGI above $500,000 would be assessed the additional 3.8% tax on their ordinary income that flows through from the S Corporation. Similarly, real estate partners could be assessed an additional 3.8% on rental income. The desire to drive income into 2021 and push expenses to 2022 is generally a good planning strategy to work through excess business loss limitation rules and mitigate the potential expansion of the net investment income tax in 2022 included in the Build Back Better Plan.
In addition, deferral of expenses to 2022 could decrease a taxpayers AGI dollar-for-dollar. Alternatively, if the excess business loss limitation is captured as a NOL in 2021 and brought into the 2022 taxable year, the carryforward may be limited as the NOL can only offset 80% of taxable income. There is also a potential 5% surcharge for AGI income over $10 million (or 8% for AGI over $25 million) included in the Build Back Better Plan, which also could be beneficial for pushing expense deductions to 2021.
5.Interest Expense Limitation: If you are reading this and don’t know what an interest expense limitation is, keep reading. It is anticipated that more businesses and individuals will be subject to the business interest expense limitation rules going forward.
Under the CARES Act, favorable adjustments were made to the interest expense limitation rules for the 2019 and 2020 taxable years in hopes of allowing businesses to have more cash to help them survive the pandemic. During the 2020 taxable year, an interest expense deduction was allowed for up to 50% of adjusted taxable income. In addition, the 2020 adjusted taxable income used in this calculation was the greater of the adjusted taxable income from 2019 or 2020 taxable year.
The favorable benefits provided in the CARES Act are removed for the 2021 taxable year. In other words, tentative taxable income must be calculated using only the 2021 taxable year information (there is no longer a choice between years), and the percentage applied to tentative taxable income decreases from 50% to 30%. The same scenario between 2020 and 2021 could generate a significantly different interest deduction based on the change in tax law.
2020 vs 2021 Interest Expense Limitation Example
The Bonadio Group
The takeaway? If you have significant interest expense in your business, you should be asking your tax advisor if the full deduction will be allowed in 2021. Are you losing the ability to deduct the total business interest expense, and potentially creating taxable income? If so, can you fall under the small business exemption or real estate trade or business exception? If an interest expense limitation is expected, are there planning opportunities to increase tentative taxable income?
Another 2021 planning consideration when dealing with the business interest expense limitation is that 2021 is the last taxable year where depreciation and amortization can be added back when determining adjusted taxable income. In other words, if depreciation and amortization are large tax items for your business, the adjusted taxable income of 2022 is most likely going to be significantly lower. If a business is subject to the interest expense limitation, they should look to escalate depreciation and amortization into 2021. For example, is there property that is subject to bonus depreciation that can be placed in service before year end? If the same property is placed in service in 2022, a taxpayer will not be able to utilize the bonus depreciation when calculating adjusted taxable income which will result in a lower deduction for allowed business interest expense.
Build Back Better Plan Interplay: The most recent bill does not significantly change the interest expense limitation rules but does suggest that the limitation no longer takes place at the business level (i.e. S Corporation of partnership level), but instead would be assessed at the individual level. While this created a sigh of relief for the tax professionals filing business returns, individual tax compliance could become much more burdensome.
6.Disposition of Property or Stock: If businesses or individuals are considering dispositions with significant gain, closing the deal in 2021 may lead to significant cash savings. Under the current law, capital gains will be subject to a maximum 20% tax rate or an ordinary income tax rate of 37%, and the sale of underlying business assets will not trigger net investment income tax.
Build Back Better Plan Interplay: If the Build Back Better Plan is passed, triggering a large gain in 2022 could significantly impact the amount of federal taxes paid. While the maximum capital gains rate remains at 20%, the 3.8% net investment income tax would be expanded under the plan to include selling active interests in partnerships or S Corporations. If you are reading this and thinking an increase of around 4% is not the end of the world, don’t’ forget about the proposed surcharge tax. If the gain causes a taxpayer’s adjusted gross income to be above $10,000,000, an additional 5% surcharge will be applied. If the adjusted gross income is above $25,000,000 the surcharge rises to 8%. An important reminder is that the tax surcharge is based on adjusted gross income and not taxable income. In other words, itemized deductions, including charitable contributions, are not going to help avoid the surcharge. All together this could result in additional tax spanning from 3.8% all the way to 11.8% depending on the size of the gain. If a taxpayer is looking to dispose of stock or property that will trigger a significant gain, and the Build Back Better Plan does pass, serious consideration should be considered for installment sales.
Lastly, investors in cryptocurrency have a significant planning opportunity ending as of December 31, 2021. As part of the Infrastructure Bill that was signed into law, the disposition of cryptocurrency, which is treated as property for federal income tax purposes, will fall under the wash-sale rules as of 1/1/2022. Therefore, if you have significant losses in a digital currency and would like to realize the loss without having to wait 30 days before reinvesting, the transaction should be completed before the end of the year.
7.Charitable Contributions: The concern over the survival of public charities during the pandemic was also considered in the CARES Act. Individuals who make qualified charitable contributions and itemize their deductions, can elect to increase the amount of their deduction to 100% of their AGI, as opposed to the traditional 60%. Cash contributions made either to supporting organizations or to establish or maintain a donor advised fund, do not qualify. In addition, cash contributions to private foundations and most cash contributions to charitable remainder trusts also do not qualify.
This increased limitation, from 60% to 100% of AGI, was allowed for the 2020 and 2021 taxable year and will revert back to 60% in 2022. Therefore, if pondering when to make significant cash contributions to public charities, 2021 could allow an increased deduction, as well as the ability to keep more cash in the bank.
Is your head spinning? Mine is. Keep in mind these are only seven areas that I chose to highlight regarding federal tax planning. State income tax planning (including evaluating the impact of remote work arrangements and the potential to optimize pass through entity tax arrangements) can make it even more complicated. What can I say? There is a reason you pay your tax accountants well. At this point, it is a good time to shoot your tax advisor an email and touch base. Heck, even ask to meet at a restaurant for lunch or dinner. The ability to deduct 100% of food and beverages purchases from restaurants for business purposes is in effect for 2021 and 2022.
On a side note, happy holidays to all. While I know this time of year can be hectic please make sure you take some time to reflect on the last 12 months. While we know that the holidays won’t be perfect, it is my belief that we are making progress and my New Year’s hope is that we will continue to do so. Wishing you and yours a peaceful holiday season with much joy and laughter.