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Year-end Tax Strategic Planning More Critical Than Ever

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As the fourth quarter of 2021 is underway, it’s becoming even more critical now than ever for businesses and individuals to review their tax strategies and be alert of the discussions in Washington D.C. Currently, Congress is debating President Biden’s ‘Build Back Better Act.’ While we all know the devil will be in the details, the early proposals at least offer a glimpse into the thinking going on in Washington.

Overall Thoughts

Most experts tend to agree that tax rates will not be going down under any proposed legislation, and the initial proposals certainly have reflected this. As a result, it might be important for taxpayers to review pulling in revenue into 2021, especially if you have NOLs from under a COVID tax year that you are pulling forward. While pulling in revenue certainly raises your current year’s tax, the net effect could potentially save money instead of paying it at a higher rate in a future year.

It will also be essential to review existing credits, such as the Employer Retention Credit. A quick quarterly comparison of revenue between 2019, 2020, and 2021 could reveal that your company qualifies for this lucrative credit – even if your business was not shut down or continued to operate during the pandemic.

Reviewing the income tax side of these credits is important, as claiming the ERC will impact your taxable income. However, the net effect of claiming the credit would keep a positive cash flow coming into your business.

Other credits exist out there that might be just as beneficial to see if your company qualifies. For example, the work opportunity tax credit exists for those that hire certain target demographics, and R&D credits may exist for certain businesses (and this may be one of the most underutilized tax credits out there). Finally, it’s always important to review potential sales tax or use tax exposure depending on your business’s activities. States are starting to get more aggressive with contractors, especially those that might fall under the manufacturing contractor definition (or construction companies that may manufacture something).

Business Tax proposals

Under the initial proposal, businesses look to have some fairly big changes coming through, whether you are a C Corp, S Corp, partnership, or a single-member LLC. For C Corporations, the 21% tax rate would be adjusted depending on your taxable income level. The initial proposals showed the following graduated tax brackets for C Corporations:

  • Taxable Income 400,000 or less 18%
  • Taxable Income over 400k & not over 5.0 M 21%
  • Taxable Income over 5.0 M 26.5%

In addition, if your taxable income hits 10 million, you are charged an additional 3% surtax to eliminate the benefit of the lowest 18% bracket. There were a lot of discussions back in 2017 & 2018 when the Tax Cuts & Jobs Act was passed on whether to structure as a C Corp or S Corp. Those discussions once again look relevant – as the capital gain rates could be changing for you as well, so getting cash out of the C Corporation could be taxed at an even higher rate – making the S Corp potentially a more attractive option. In addition to the rate changes, there were a few changes related to foreign taxes should you have international business as well as the dividends received deductions.

These new brackets would be effective for tax years starting after 2021.

Individual Proposals

For owners of S Corporations, partnerships, and single-member LLCs, there were quite a few changes on the individual side that will impact your business. The one that is probably getting the biggest attention would be the changes in tax rates to the top bracket. Currently, the top bracket is 37%, but under the proposed legislation, it would be raised to 39.6% at the following levels:

  • Single – $400,000 (Projected 37% 2022 bracket is $539,900)
  • MFJ – $450,000 (Projected 37% 2022 bracket is $647,850)
  • MFS- $225,000 (Projected 37% 2022 bracket is $323,925)
  • H of H- $425,000 (Projected 37% 2022 bracket is $539,900)

The other tax brackets appear to be unchanged at this time, but this will need to be reviewed as well as details are worked out. Like the C Corporation rates, the above brackets would be effective for tax years starting after 2021.

Capital gain rates would also be changing under the proposed legislation. Currently, capital gains are taxed at 0%, 15%, or 20%, depending on where your taxable income is at for the year. Under the proposed legislation, the 20% bracket would be replaced to 25%. Thus, potentially putting your C Corp earnings at an effective tax rate of 46% or even 51.5% (before the state gets its piece of the pie!)

In addition, the capital gain rate would be split in 2021 as the new rates kick in starting September 13, 2021 (the date the proposed bill was introduced). This starting date will create some recordkeeping issues to make sure the capital gains are reported and taxed properly in 2021. The 25% rate would start with taxable income at the 39.6% bracket levels listed above. The 0% and 15% rate brackets would remain unchanged.

Qualified Business Income Deduction

The 199A deduction for pass-through entities has been a very positive deduction for small businesses to take. It effectively eliminates 20% of your business income (subject to limitations) right off the top. While the current deduction is set to phase out after 2025, the proposed legislation looks to limit the amount of deduction you can take and does NOT extend it past 2025. The deduction would be limited to 500,000 for joint filers/surviving spouses, $250,000 for married filing separate filers, $10,000 for estates and trusts, and $400,000 for all other taxpayers.

So, if your pass-through income is over 2.5 million for a joint filer, your deduction will be limited. For a single filer, that limit kicks in at 2.0 million.

Individual Tax Credits

Currently, individual tax credits have already changed. The IRS is prepaying a portion of the child tax credit, which taxpayers need to realize this is an advance that will effectively lower the amount of credit you would otherwise claim when you file your 2021 returns. The proposed legislation expands the credit into 2022 and provides a monthly credit 2023-2025.

Passing Your Business On & Retirement

Transitional planning is critical as well. The proposed legislation impacts estates & trusts from new rates to accelerating the expiration of the estate and gift tax exemption (currently $12,060,000) which is set to revert to $5.49 million in 2026, would be pushed to 2022.

Retirement planning could be impacted as well as the proposed legislation caps the amount of allowable retirement account balances for high-income earnings at $10 million (high-income earners are those subject to the proposed 39.6% rates). There would be an excise tax on any contribution over the $10 million-dollar balance (subject to inflation), and RMDs would be increased.

The proposed legislation also hits rollovers to Roth IRAs – preventing high-income earners (39.6% bracket) from doing it all together. In addition, a general prohibition regardless of your income level would prevent conversion to a Roth IRA of any amounts consisting of after-tax contributions in an employee-sponsored plan.

Closing the Tax Gap

The proposed legislation also provides additional funding to help the IRS close the tax gap. The tax gap is the difference between what was collected versus what should have been collected. While I think we can all agree tax cheats need to be caught, as a business owner, this potentially increases audit risks, so strong record keeping will be a must.

Final Thoughts

The information here is just the tip of the iceberg and shows the importance of getting together with your tax advisor as 2021 starts to wind down. In the end, all the proposals discussed in this article may not come to reality. But, at a minimum, it shows the trends in the tax community, and the expectation is that some of these will happen in some form. Reviewing your tax strategy often continues to be an essential part of operating your business, and we are here to help.

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