2021 TAX PLANNING
With the Democrats controlling both houses of Congress, there is a likelihood that President Biden’s tax proposals may pass this year. To understand what new tax laws might look like, we can examine what has been proposed, what Biden talked about during the campaign, and some ideas that have been brought up since the campaign. While we have no way of knowing what actual tax law will be passed, it is helpful for taxpayers to know at least what has been discussed as they connect with advisors to have 2020 tax returns prepared and look ahead to 2021 tax planning.
Income Taxes
In terms of income tax rates, Biden has proposed a return of the top individual tax rate to 39.6%, up from the current 37%. This would affect those with taxable income above $400,000. There are a lot of questions about what that means exactly: Is the $400,000 threshold for a single taxpayer or married filing joint (MFJ) taxpayers? Would there still be a difference at the top rate for those two classes of taxpayers?
It is important to keep in mind that, under current law, the top individual tax rate is already slated to go back up to 39.6% in 2026, because the individual portions of the tax law that was passed at the end of 2017 were temporary changes.
Biden’s proposal also would increase the tax rate for C corporations from the current flat tax rate of 21% to a tax rate of 28%. This is still well under that 35% rate that many professional practices were taxed at as personal service corporations in the past, but it would be an increase from today’s position.
Social Security Taxes
A significant change for many would be President Biden’s proposal to assess Social Security tax on wages above 400,000. Under current law for 2021, employees pay 6.2% and employers pay another 6.2% on the first $142,800 of wages for each employee. President Biden’s proposal would have that same tax — 6.2% for employees, 6.2% for employers — assessed again once wages exceed $400,000. This would create a wage gap from $142,800 up to $399,999, where there would not be any Social Security taxes on the wages, but once an employee reaches $400,000, Social Security taxes would again be assessed. Remember that this tax is in addition to Medicare taxes of 2.9% to 3.8% which are already paid on an unlimited amount of wages.
Consequences of this proposal, if it becomes law, include an increased importance of how businesses, including medical practices, are structured tax-wise and how they pay compensation to the owners. For example, if a business or practice is taxed as an S corporation, it will be even more important for the owners to determine how they can minimize the amount of compensation as wages — while remaining “reasonable” as required — and maximize the amount of owner distributions.
C corporations, which typically try to eliminate their net taxable income at the corporate level by paying out bonuses to the owners in the form of W2 wages, may become even more problematic tax-wise if this proposal becomes law. We would not be surprised if many business/practice owners look to convert C corporations to S corporations as part of their analysis under a new tax law.
Capital Gains and Qualified Dividends
If passed, the segment of President Biden’s tax proposal concerning capital gains and qualified dividends would represent a major change from the status quo for the highest earning taxpayers. His proposal includes taxing capital gains and qualified dividends at ordinary income tax rates for taxpayers earning over a million dollars. Currently, the tax rate on long-term capital gains and dividends for taxpayers in the highest tax bracket is 20% plus 3.8% net investment income tax under the Affordable Care Act for a total of 23.8%.
This proposal would bring capital gains taxes for those making more than a million dollars up to the 39.6% rate, presumably still with the 3.8% surtax. If this proposal becomes law, these earners will need a keen focus on managing capital gains, harvesting losses against gains, and sharpening an awareness of the tax drag on investments.
Also, for owners selling or merging their businesses/practices, installment sales may become more valuable by dictating that income is received over the course of more than one year, thereby attempting to keep the owner’s income below the $1 million threshold.
Itemized Deductions
President Biden has proposed capping the value of itemized deductions at 28% for those in the top tax bracket. As an example, a taxpayer at the 39.6% tax rate who deducts mortgage interest would get a benefit of only 28 cents for each dollar of the deduction, instead of 39.6 cents on the dollar. In other words, these deductions would be worth less to a high-income taxpayer in terms of their capacity to reduce taxable income.
President Biden has also proposed to restore the Pease limitations for those with more than $400,000 in taxable income. The Pease limitations, which essentially reduce itemized deductions for high-income taxpayers, were eliminated by the 2017 Tax Cuts & Jobs Act.
There is one piece of good news, especially for residents of states that have high state and local income taxes or high property taxes. It has been reported that President Biden, along with Speaker Pelosi and Senator Schumer, are in favor of getting rid of the current state and local tax deduction limitations (SALT limitations), which limit a taxpayer to a maximum total deduction of $10,000 for all state and local income taxes and real estate taxes. If the SALT limitations are repealed, taxpayers could go back to being able to deduct all of their state, local and real estate taxes on their federal tax returns.
Childcare Credits
For parents who pay for childcare, the current law limits expenses that can be used toward the child and dependent care credit to $3,000 per child per year or $6,000 for multiple children. For those with adjusted gross incomes above $43,000, the credit is limited to just 20% of these expenses. Biden’s proposal includes an increase in eligible expenses to $8,000 for one child and $16,000 for multiple children, with a credit of up to 50% of those expenses available for taxpayers earning up to $125,000.
Gift and Estate Taxes
Under President Biden’s proposal, the estate tax exemption would be reduced back to 2009 levels, which would be an individual estate tax exemption of $3.5 million and a gift tax exemption of $1 million. Currently, the estate and gift exemptions are both over $11 million per person.
Timing
Not only do we not know which tax proposals will become law, we also do not know when any new tax law would become effective. A new tax law can be retroactive to January 1 of the year it passes or may not take effect until January 1 of the following year. In other cases, new tax law could be partially in place for the year of passage (i.e., 2021), with some aspects effective in 2021 and other aspects not effective until 2022.
Conclusion
While it is important to prioritize forward-looking tax planning every year, it is even more so this year with the possibility for significant tax law changes on the horizon. Taxpayers in all income tax brackets should commit to staying updated on the present proposals that may become part of a new tax regime and consider planning options that may help to mitigate any detrimental impacts of a new law.