We are nearing the end of calendar year 2020 (thankfully!) and it is time to consider end-of-year tax planning. Due to the outcome of the election, there is significantly more certainty about the possibility of tax law changes in the near term (even though control of Congress remains undecided) as well as the availability of a vaccine. This increased certainty (if not complete) is helpful.
The chances that the significant tax increases for high income taxpayers that Democrats proposed during the campaign will become law next year look to be very low. It is also unlikely that there will be a wholesale repeal of the Tax Cuts and Jobs Act of 2017. It is even less likely that any significant tax changes could be made retroactive to Jan. 1, 2021.
When President-Elect Biden takes office, he will do so with a slimmed down House majority and a likely Republican majority in the Senate. The Republicans will maintain their majority if they can win one of the Georgia run-off elections (in which they are favored by pundits and betting markets). Even if Democrats are able to win two run-offs in Georgia, Democrats would have a very weak majority of 50 Senators plus Vice President Harris as a tie-breaker. Even if the Democrats use the reconciliation process to move tax legislation, this would give every Democratic Senator a veto over the legislation. Without the reconciliation process, passage would require 60 votes to prevent a filibuster, a rule which looks likely to remain in place for now.
Nonetheless, divided government does not mean that there won’t be tax changes—as the President and Congress focus on other areas of legislation, they may choose to offset spending with tax changes (like the provisions in the SECURE Act, which changed the rules for inherited IRAs). There is a contingent of the Democratic Caucus that is supportive of tax increases (and aggressive tax collection efforts) on high net worth individuals. It is unclear how this will play out in legislation.
As of this writing, President-Elect Biden has announced Former Fed Chairwoman Janet Yellen as his pick for Treasury Secretary. Yellen was considered a consensus pick who was less likely to immediately adopt an aggressive approach to regulation and administration compared to others who were under consideration. It remains to be seen who will fill lower-level appointments (appointments who could have more influence on the IRS regulatory approach).
All of this means a fairly standard approach to end-of-year planning:
Income Tax Planning. The proposed increases in the long-term capital gains rate from 20% to 39.6% for high income taxpayers (and additional social security taxes) are not very likely to occur in 2021, although a new administration and Congress may attempt to wring some revenue generation out of small tweaks to the preferential capital gain rate or other tax provisions. Given the relatively low likelihood that taxes will increase in 2021, it appears that any advantage from accelerating income into 2020 (in order to “lock in” the 2020 20% capital gain rate) would be offset by the disadvantage of paying the income tax early (and losing deferral).
Instead, the standbys of income tax planning applies—harvest losses now, defer gains (and taxes) until later. Hopefully, taxpayers were proactive about harvesting losses in March and April (or there may not be many losses to harvest).
In recent years, taxpayers in high income tax states have considered moving their residences to a low-income tax state; with recent Supreme Court decisions, it has also potentially become attractive to move the administration of trusts in order to avoid state income tax. The value of this planning may be blunted because it is likely that President Biden may seek to reinstate the federal income tax deduction for state and local taxes. On the other hand, cash-strapped states are likely to increase their state income tax rates. Arizona used to be seen as an income tax haven, but it passed Proposition 208, which increases the top state income tax rate to 8% on income over $250,000. Illinois did not adopt the constitutional amendment required for a graduated income tax, and the state income tax will, at this point, remain at 4.95%.
For charitably minded taxpayers, the CARES Act has provided a one-year opportunity to offset all taxable income with a cash gift to charity, as long as the contributions are made to 501(c)(3) organizations other than non-operating private foundations, donor-advised funds, and supporting organizations. The legislative wording indicates that the CARES Act allows taxpayers to make contributions of appreciated property and contributions to private foundations and donor advised funds subject to the usual AGI limitations and then make additional cash gifts to public charities to take advantage of the 100% AGI deduction. Taxpayers may choose to have the usual limitations apply and carry over excess contributions to a future year. (Depending on the situation, this may be better if the taxpayer can use the deduction to offset ordinary income in future years as opposed to long-term capital gains in the current year.)
For taxpayers looking to shelter capital gain, the IRS has extended the period for reinvesting capital gains in an Opportunity Zone until the end of the year. Depending the specifics, a taxpayer would be able to defer his capital gain for five years (through 2026) and permanently eliminate 10% of the capital gain if the Opportunity Zone investment is held for five years. The taxpayer will also enjoy tax-free growth on the underlying OZ investment itself if it is held for 10 years.
If 2020 will be a loss year, a taxpayer may want to accelerate deductions into 2020 in order to take advantage of the CARES Act loss provisions, which suspend limitations on losses imposed by the TCJA. The CARES Act suspended the excess business loss rule for tax years before Jan. 1, 2021 (the excess business loss limitation limits non-corporate taxpayers from claiming net business losses above a threshold). In addition, the net operating loss limitations are suspended for tax years before Jan. 1, 2021 (such losses may be carried back five taxable years without the 80% limitation on such losses).
Estate Tax Planning. Given that the Senate will be controlled by Republicans or split 50-50 with a Vice Presidential tie-breaker, it is unlikely that the additional gift and estate tax exemption (now $11.58 million) will be repealed. The exemption is scheduled to revert to $5 million in 2026 (the exemption will probably closer to $6 million when adjusted for inflation). Even though it looks like the additional exemption amount will survive into next year, it remains a historically opportune time to engage in estate planning because of low valuations and low interest rates (low interest rates improve the efficiency of grantor retained annuity trusts and installment sales to grantor trusts to transfer assets to the next generation without incurring gift tax).
Despite major upheavals in 2020, general income tax planning remains the same: accelerate losses and deductions, defer gains, and be proactive with the estate tax.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.