To Deduct or Defer: How to Make a Tax Plan in an Age of Uncertainty

President-elect Joe Biden’s victory has led many business owners and organizations to ask, “How does the outcome of the election impact my 2020 year-end tax planning?” Given 2020’s unprecedented amount of turbulence and change, this question is even more important than usual and the answer is more complicated than usual

The backdrop

To begin, it’s important to understand the current political landscape and its potential impact on the legislative process. The increased political certainty that Joe Biden is our President-elect doesn’t tell us much about the likelihood of any potential tax reform. As with any legislative process, what originates in the House of Representatives is then transferred to the Senate — where it can be amended or replaced — before both chambers agree to identical legislation and the bill is sent to the president for a signature or a veto.

While Democrats held on to a majority in the House, control of the Senate depends on the results of the two Georgia runoff elections on January 5, 2021. Should Republicans win just one of those races, they would maintain control of the Senate, which would significantly impact and complicate the trajectory of any proposed tax legislation.

As some tax planning is time sensitive and has to be decided before the end of the year, this context can be frustrating as we wait until 2021 to know the legislative layout. However, focus on things you  do know and outcomes you can control.

While no one can say how a deliberative legislative process may unfold, there is insight into President-elect Biden’s tax reform proposals that were released during his campaign. Review key provisions of the Biden tax platform.

Biden's proposed tax plan
	Current rate	Biden proposal
Top ordinary income tax rate	37%	39.6%
Top capital gains rate*	20%	39.6%
Estate tax**	40%	45%
Corporate income tax	21%	28%

*For taxpayers earning more than $1 million
**Lower $3.5 million estate tax exemptions for individuals, $7 million for married couples, also proposed.
Source: Bloomberg Tax

Notice a proposed increase on both personal tax rates — for those with income above $400,000 or capital gains exceeding $1 million — and corporate income tax. If these tax rates pass muster and both chambers of Congress approve quickly, the potential implementation timeline is still unknown and subject to the legislative process. Build flexible plans founded on sound business decisions.

Build a flexible plan

While some elements of a good tax plan (such as charitable giving) must be completed before the end of the year, there is much that can be done after year-end. Take advantage of hindsight and the gift of extra time. Consider extending your return to gain knowledge and clarity about the likelihood of tax reform, which will help you make holistic decisions and build a better plan. Review a few flexible tax plan ideas that can be evaluated after year-end.

Section 179 expensing

Many taxpayers evaluate capital expenditures prior to year-end. Capital expenditures can provide tax deductions and be part of a strong overall tax plan strategy (if the assumption of such outlays also makes good business sense). In 2020, you can expense up to $1.04 million of eligible property placed in service during the tax year, as long as total additions are not in excess of a threshold amount of $2.59 million.

After year-end, this tool can be part of an effective tax strategy because it is an annual election made on a property-by-property basis, and you can specify how much of a property’s cost basis to expense. Although taxpayers generally benefit by accelerating the timing of deductions, potential impending rate changes may create situations where increasing current-year taxable income and receiving the deferred depreciation deductions in future years is more advantageous.

Consider the ability to elect or forgo Section 179 after the close of the taxable year to keep tax plans nimble in uncertain times.

Bonus depreciation

Should you require equipment investments (and should you find it fits into the overall cash flow plans), consider bonus depreciation as a potentially effective capital expenditure strategy that provides the ability to alter taxable income after the close of the tax year.

However, bonus depreciation is not as flexible as Section 179 expensing, because it only allows taxpayers the ability to make the election out of bonus for each separate class of property (e.g., five-year modified accelerated cost recovery system, or MACRS, versus seven-year MACRS). To most effectively use this strategy, model your outcomes to determine which classes to write off 100% bonus, versus which classes to elect out of bonus.

In 2020, you may find it advantageous to accelerate significant deductions with a combination of bonus depreciation and other strategies in order to create a loss to carry back to years with higher tax rates. This may be more beneficial than deferring deductions to future years. Weigh these options with a tax professional to create a roadmap tailored to your individual situation.

Cost segregation and fixed asset studies

A cost segregation study identifies building assets — whether newly constructed, purchased, or renovated — that can be depreciated at an accelerated rate using a shorter depreciation life. If the expense of the construction, purchase, or renovation was in a previous year, favorable IRS rulings allow taxpayers to complete a cost segregation study on a past acquisition or improvement and take the current year’s deduction for the resulting accelerated depreciation not claimed in prior years.

These catch-up deductions are taken as an accounting method change via a catch-up adjustment sometimes known as a Section 481(a) adjustment, which can be done on an originally filed return — including extensions. Therefore, you can quantify this benefit and use this information to decide if it makes sense to include any catch-up deductions on your 2020 filing, or if it would be more advantageous to defer to 2021.

Many factors can impact when you decide to file an accounting method change. If the Section 481(a) adjustment is large enough to generate a loss in 2020, you may want to take the deductions in 2020 to carry the loss back — up to five years to high tax rate years — rather than deferring deductions to 2021, even if rates may increase in future years. As always, the appropriate strategy can only be determined by an examination of your own circumstance.

Accounting methods

Consider implementing accounting method changes to potentially improve your tax position. Utilize accounting method changes — with careful attention to consistency and timing, as well as your fact pattern and desires — to accelerate deductions or income, or to defer deductions or income.

Accounting method changes can provide great post-tax year planning for automatic change requests because they can be filed at any time during the year in question, and on or before the extended due date of the tax return for the year of change. The cumulative catch-up adjustment known as the Section 481(a) adjustment represents the accumulated amount of income or deduction at the beginning of the year of change (which is necessary to prevent duplication or omissions as the taxpayer converts from the former to the new method of accounting). In general, income pickups are spread over four years — beginning with the year of change — while negative adjustments are picked up entirely in the year of change.

The list of automatic accounting method changes is expansive. Consider automatic method changes, such as:

• A change of your overall method of accounting from accrual to cash method or vice versa
• Certain inventory methods such as the subnormal goods or lower of cost or market methods
• Acceleration of deductions for prepaid expenses
• Accounting for advance payments

Installment sale reporting

You may face succession events, as many Baby Boomers look for exits — especially with the headwinds and uncertainty that the pandemic has created. Often, these succession events come with large payouts that may occur over a series of years. An installment sale involves a disposition where at least one payment is received after the close of the tax year in which the sale occurs. Under the installment sale rules, a taxpayer recognizes a portion of each payment as gain when received. Installment sale reporting is mandatory unless the taxpayer elects out of it — however, watch out for related party sales and dealer sales, which are ineligible for installment sale reporting.

Generally, installment sale reporting is beneficial because capital gains are spread over a series of years and the tax paid aligns with the cash receipts. Installment sale reporting may still be a good strategy even with the potentiality of future tax reform — if the receipts and gains are allocated across future years in such a way that the taxpayer’s adjusted gross income (AGI) stays below a given threshold.

However, evaluate whether it makes sense to elect out of the installment method and report the entire gain in the year of sale. This could be beneficial if capital gain rates are expected to increase or you have other attributes set to expire that could help offset the income pickup (including net operating loss carryovers, charitable contribution carryovers, and business tax credit carryovers).

Leverage hindsight from your tax return extension to carefully model and evaluate this decision.

Opportunity zones

The 2017 Tax Cuts and Jobs Act created incentives for the reinvestment of gains through a qualified opportunity zone fund (QOF) into certain economically distressed areas (referred to as “opportunity zones”). Benefits of investment include deferral and permanent gain exclusion as follows:

• Deferral of gain invested in the QOF until the earlier of:
  • The day the QOF is sold or exchanged or,
  • December 31, 2026.
• Permanent exclusion of up to 10% of the deferred gain if the QOF is held at least five years; and,
• Permanent exclusion of the post-investment appreciation in the QOF if the investment is held at least 10 years.

Some taxpayers have raised concerns about this gain deferral in the event of potential future tax policy changes. However, for a QOF project that performs as expected, an increase in capital gains tax rates would only accentuate the positive benefits of both the QOF gain exclusion and the initial gain deferral period. These benefits could outweigh the negative impact of higher taxes due in 2026.

Note that in order to qualify, the gains must be reinvested within a 180-day period. This investment window aims to provide ample time to identify high-quality investments and to understand options for tax plans after the gain is triggered. Favorable regulations have been issued that allow deferral of gross Section 1231 gains, as well as flexible opportunities that allow installment sales to have a single period to make a deferral upon the initial transaction (or as each installment is received).

Evaluate retirement plan contributions

Certain qualified plans provide the ability to fund tax-deductible employer contributions to retirement plans up until the due date of the tax return (including extensions) for the year in which a contribution is allocated. Do your homework to help understand key milestones for these qualified plans, including deadlines to set up the plan, funding limits, and funding deadlines.

Once again, hindsight may provide you the ability to better understand your tax liability and make better decisions.

How we can help

An individualized, thoughtful, and effective tax plan is more important than ever before. The tax professionals at CLA can help you develop a clear roadmap with multiple paths and flexible scenarios and assist you with changes and uncertainty as they come. No matter the legislative outcome, a nimble plan can keep you on a path toward the achievement of your financial goals.

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