The fourth quarter has officially started, and for us tax lawyers, all thoughts have turned to year-end planning to minimize our clients’ exposure to taxes. This is true even for those who did not feel or exult in the immediate impact of the largess bestowed on us by Congress with the passage of the Tax Cuts and Jobs Act (TCJA) signed into law almost two years ago. Being the largest major tax reform in over 30 years, the IRS has been busy releasing guidance and new forms to incorporate the new aspects of the law. The following is intended to highlight some of the planning you may wish to consider, and why.
Tax Rates and Timing. The old adage remains the same: defer income to the next year and accelerate deductible expenses into the current year. But don’t ignore the possibility that you may end up in a higher bracket next year than this year. Although tax rates on “ordinary income” generally went down under the TCJA, and these rates have been legislated to stay in effect through 2025, election-year politics could change the sunset dates of the Act, albeit the possibility of that happening with an effective date that would impact the 2020 calendar year has to be considered very remote.
The following are some deductible expenses that could be accelerated (prepaid) by December 31st:
- Charitable contributions (up to 50% of adjusted gross income (AGI) for cash and tangible personal property; up to 30% of AGI for capital assets)
- State and local income taxes and property taxes (but see discussion below on new limitations)
- Mortgage interest (consider repaying January’s loan payment, or just the interest element of the payment)
- Investment interest (pay any margin interest before the end of the year; accrued interest is deductible only if actually paid)
- Business equipment (if purchased and placed in service before year-end could qualify for $1M expense deduction, and/or 100% bonus depreciation)
The following are some types of income that can be accelerated; although controlling the timing of these may not be so easy:
- Cash salaries and bonuses
- Self-employment income (if cash-basis business, and anticipate 2019 rate to be lower than 2020 rate; try to collect receivables this year)
- Retirement Plan Distributions (if over the age of 59-1/2, and tax rate low this year, consider either (i) a distribution even if not needed; or (ii) Roth conversion. If over the age of 70-1/2, consider distribution direct to public charity from an IRA, up to $100,000)
- Capital Gains (consider selling positions with unrealized short-term gains, if next year’s rate may be higher, and if you don’t intend to hold the position for at least 12 months; these gains can also offset long term capital losses)
Timing and Impact of TCJA. The most significant change to itemized deductions made by the TCJA, which has received a lot of press, is the deduction for state income and local property taxes. Through 2025, there is a combined limit for both of these items of $10,000 per year. There are some planning opportunities to work around the property tax limitation, which many people with expensive homes located in high-tax assessment jurisdictions have implemented. The TCJA also changed the mortgage interest and home equity debt interest deductions, and suspended through 2025 the miscellaneous itemized deductions subject to the two-percent floor. This deduction included certain professional fees, investment expenses, and unreimbursed employee business expenses. To offset the loss of many of these popular and well-known itemized deductions, the TCJA increased the standard deduction, nearly doubling it to $24,000 for married taxpayers filing jointly.
Owner-Employees. Recognize that income passed through to you, as the owner, for those types of entities where pass-through of income is the rule (e.g., S corporations, partnerships, and limited liability companies), even if not distributed, will be subject to self-employment taxes. With an S corporation, only income you receive as salary is subject to employment taxes and, if applicable, the 0.9 percent Medicare tax. Therefore, depending on current and prospective tax rates, consider keeping salaries from an S corporation as low as possible, and pick up the remaining earnings on the K-1, which is not subject to self-employment taxes (see discussion below on Section 199A deduction).
Investments. Tax treatment of investments varies significantly based on factors such as the type of investment, type of income it produces, holding period, and whether any special limitations or benefits apply. Long-term capital gains rates were not modified by the TCJA. But the changes it made to ordinary income tax rates and tax brackets do have an impact on the timing of the recognition of gains and losses and the tax consequences of the same. Again, through 2025, the top long-term gains rate of 20 percent applies at income levels much lower than that before the top ordinary-income rate applies.
Wash Sale Rule. If you are considering selling a stock investment as described above to recognize a loss, but you really like the particular asset that you are targeting for sale to produce that loss, and you are thinking about buying it back, do not overlook the wash sale rule. No deduction is allowed if you acquire substantially the same securities within a 61-day window, beginning 30 days before the sale and ending 30 days after the sale. Here a few methods by which you may be to avoid the rule:
- Sell the security and purchase the same securities no sooner than 31 days later.
- Buy more of the same security, wait 31 days, and then sell the original lot.
- Sell the security and reinvest the proceeds in a mutual fund that invests in companies similar to the one you sold, or in a stock of another company in the same industry.
Qualified Small Business Stock (QSB) – Deferral and Exclusion of Gain. To be a QSB, a business must be a C corporation engaged in an active trade or business and must not have assets that exceed $50 million. The TCJA gave such an investment a huge advantage by reducing the C corporate rate to a flat 21%, reducing it from 35%. If QSB stock is sold and the proceeds are used to acquire stock of another QSB within 60 days after the sale, the tax on the gain can be deferred until the new stock is sold. If the proceeds are not reinvested, a gain can still be excluded depending on (i) the date of acquisition, and (ii) how long the stock was held. Up to 50% of the gain is excluded if the stock was held for at least five years. But if the stock was acquired between February 17, 2009 and September 28, 2010, 75% of the gain is excluded; and if acquired after September 28, 2010, 100% of the gain is excluded. The non-excluded portion of the gain is taxed at lower of your ordinary income tax rate, or 28%, making the effective tax rate on a sale of QSB stock 14%.
Real Estate Investments. The TCJA included many changes affecting the tax benefits attributable to real estate investments, including a principal residence, vacation home, or rental property. As stated above, through 2025, there is now a $10,000 limit on combined deductions for state income and local property taxes. The mortgage interest deduction is still as close to sacrosanct as you can get in the tax code. You generally can deduct interest on mortgage debt incurred to purchase, build, or improve your principal residence and a second residence. But through 2025, the interest that can be deducted is limited to mortgage debt of $750,000 for debt incurred after December 15, 2017, which represents a reduction from $1M of debt in prior years.
The TCJA also removed prior law restrictions for Section 179 deductions for personal property used in connection with furnished lodging. Examples include furniture, kitchen appliances, and other equipment used in the living spaces of a property such as a motel, hotel, apartment condominium, or single-family home. The $1M deduction is also available for improvements to the interior portions of a nonresidential qualifying real property, with certain limited exceptions.
Section 199A Deduction. TCJA also introduced a new deduction for (non-corporate) owners of pass-through entities. Through 2025, sole proprietors and owners of pass-through business entities can deduct 20 percent of qualified business income (QBI). There are various limitations on the QBI deduction, and there are various taxable income thresholds over which these limitations apply. Therefore, business owners will want to take a hard look at increasing the component parts of this income limitation in order to enhance the deduction, but at the same time need to examine the possible side effects of reducing this year’s taxable income, which could reduce the QBI deduction.
For questions, comments or additional information, please contact Joel Luber, Chair of our Estates & Trusts Group, at firstname.lastname@example.org or via phone at 215.495.6519.