Last Minute Tax Planning For 2020

We are nearing the end of 2020, which will be a relief to many of us. As always at this time of year, it’s a good idea to be sure we’ve done everything we can to get the best result from a tax standpoint. This has been a challenging year, and a number of changes to tax law were made to address some of those challenges. There are also many other issues that should be considered every year. This is intended to be a tax planning tool, and not an exhaustive summary of tax law.

Stimulus Payments, Unemployment and Forgivable Loans

Let’s look at some of the payments resulting from the COVID pandemic response:

Stimulus payments – the payment of up to $1,200 per person, and $500 per dependent child – are not taxable.

Unemployment payments are taxable on your federal return. That means you may have a payment due if you didn’t withhold tax from your payments, or if your tax rate is higher than the withholding rate. Some states tax unemployment, but others don’t. California, for example, does not tax unemployment payments. That includes the federal supplements of 2020.

Forgivable PPP loans for your business are not taxable income. Note though, that payroll and other authorized expenses you paid with the loan proceeds will not be tax deductible. The expenses may not be deductible, but they were fully reimbursed, so you come out significantly ahead.

Itemized Deductions vs Standard Deduction

Most taxpayers are entitled to the Standard Deduction, so unless your deductible items add up to more than the Standard Deduction there is no need to keep track of them.

The Standard Deduction is $12,400 for a single person, and $24,800 for a married couple, up from $12,200 and $24,400 in 2019. These amounts are increased if you or your spouse are over age 65 or blind. It can be reduced if you are someone’s dependent.

If you have deductible expenses in excess of the Standard Deduction, you can claim them as Itemized Deductions. Here is a summary of deductions you can and can’t deduct.

What You Can Deduct:

Medical expenses – You can deduct medical expenses that exceed 7.5% of your income. They include medical and dental expenses for you and your dependents, including those who you could have claimed, except their income was too high. Medical expenses are deducted when they are actually paid, so you can accelerate or delay payments to maximize your deduction in a given year when you might exceed your standard deduction.

State and local taxes (SALT) – State income taxes, real estate taxes and personal property taxes are deductible, but they are limited to $10,000 whether you are single or married. The limit is $5,000 if you are married, but filing separately. A common practice in the past, of accelerating payment of property taxes is no longer beneficial to most taxpayers.

Mortgage interest – Interest on home mortgages secured by a primary or secondary residence is an Itemized Deduction, subject to specific limits. Interest on loans of up to $750,000 is deductible, whether you are single or married. The limit is reduced to $375,000 if you are married, but filing separately. If you secured the mortgage before December 17, 2017, though, the limit is $1,000,000. The debt must be “acquisition debt,” which means the loan must be for the acquisition, construction or major improvement of the home. A deduction in previous years   for interest on $100,000 of secured debt for unrelated purposes is no longer available. The $1,000,000 limit remains on refinanced amounts on loans secured before December 17, 2017, as long as it doesn’t exceed the outstanding balance at the time of refinancing. States may have different rules. California, for example still complies with the rules before December 17, 2017.

Charitable donations – Charitable donations are deductible, up to 100% of your income, if you donate cash to qualified organizations. Excess amounts can be carried forward to future years. The 2019 60% limit has been suspended. If you don’t itemize expenses, you can still take an “above the line” deduction for up to $300 in 2020. The limit is 30% for gifts of stock or other appreciated assets, which is discussed later in this article. A combination of cash and appreciated asset donations can be made up to 50% of your income. If your itemized deductions are below the Standard Deduction, making a larger donation every second or third year could put you over the threshold in those years.

Gambling expenses, up to the amount of winnings, and investment interest, up to the amount of investment income, are Itemized Deductions.

What You Can’t Deduct:

Casualty and theft losses – You can only deduct losses in a federal disaster area for federal purposes. States may allow deductions for other losses not covered by insurance for casualty and theft. California allows these deductions, and does not conform with federal tax law.

Unreimbursed employment expenses – Business expenses for employees (NOT self-employed or 1099 workers) are not deductible on your federal tax return. These include union and professional dues, education expenses, home office expense, mileage, travel and meals, and other usual and necessary expenses incurred for the convenience of your employer, but which the employer will not reimburse. Note that some states differ from the federal rules, and allow these deductions – California is one of those states. If you have substantial expenses of this nature, you may benefit from a change of status from employee to independent contractor, although there are important issues related to independent contractor status, as discussed later. If your income is relatively high, you should consider forming an S Corporation, as I also discuss later. I have other separate articles on S Corporations on my website.

Alimony - Alimony is not specifically an Itemized Deduction, but this seems to be a good place to discuss it. Alimony payments related to divorce or separation agreements finalized after 2018 are not deductible. If your divorce was finalized before December 31, 2018, though, you can still deduct the payments. Child support payments are not deductible.

Investment expenses – Fees paid to investment advisors are not deductible on your federal tax return. Speak to your advisors to see if they can replace advisory fees with transaction-based fees, which are still deductible.

Legal expenses – Most personal legal expenses are not deductible. Business related legal expenses are still deductible, as are fees related to discrimination lawsuits. Note that many employer lawsuits can be considered discrimination lawsuits. Legal fees for divorce or child support are not deductible. Some states may have different rules and limits on deductible legal expenses.

Hobby and not-for-profit rental expenses – You have to report income from hobbies and casual rentals, but you can’t deduct the related expenses, although states may differ. No, it doesn’t seem fair. If you can generate a profit from these activities in some years, though, they could be considered for-profit business activities, and you could deduct your expenses in that case. Some states, including California, may allow deduction of expenses up to the amount of income from these activities.

Tax preparation fees – Personal tax preparation fees are not deductible on your federal return, but states may differ. Fees for preparation of business or rental returns are still deductible, though.

Health Insurance – Individual Mandate

There is no longer a federal penalty for not having health insurance. This is not a good reason to terminate your health insurance policy, but the penalty is gone. Subsidies are still available under the Affordable Care Act.

It is important to note that some states may have penalties for not having health insurance. California and Massachusetts are examples.

Defer Income / Accelerate Deductions

There are opportunities to defer income items that would be taxable this year, and move them into next year. You may also be able to pay certain deductible expenses this year that you might have waited to pay next year. This strategy only makes sense, of course, if you are not expecting to be in a higher tax bracket next year.

If you have business income, you can delay billing your customers or clients, so you don’t receive payment until after December 31. Similarly, you can speed up payment of some of your expenses to get a deduction this year. The Qualified Business Income Deduction (QBI) phases out above certain income limits, so it may be an important consideration if you can keep your income below the thresholds. It is discussed later in this article.

If you have a rental property, and your income is under $100,000, you may be eligible to deduct up to $25,000 of rental losses against your regular income. The deduction phases out completely when your income goes over $150,000. It is a good incentive to defer income or accelerate expenses if you are in this range.

Talk to your employer about receiving any year-end bonus after December 31, so you don’t pay tax on it until next year. Alternatively, think about contributing your bonus to your 401(k) account. More on this later.

Alternative Minimum Tax (AMT)

Alternative Minimum Tax applies to fewer taxpayers than in the past. Incentive Stock Options are still an AMT item, so speak to your tax advisor well in advance of exercising any ISOs, as careful planning could reduce the tax impact.

Investment Income / Losses

Take Investment Losses - If you have losses on taxable investments, think about selling them this year. They will offset any capital gains you may have, but even if your losses are more than your gains, you can use up to $3,000 to reduce other income, and you can carry any excess losses forward to future years. Important: If you sell stock at a loss, and repurchase it within 30 days, it is called a Wash Sale, and you can’t deduct the loss. You can’t repurchase it in your IRA, either.

Consider investment in REITs – The Qualified Business Income (QBI) deduction applies to qualified REIT dividends, so taxable income is reduced by 20%.

Timing of mutual fund investments – Purchase mutual fund shares after the dividend date, or wait until after the end of the year. If you buy now and receive a dividend in 2020, you will pay tax on the dividend, and the value of your investment will be reduced by the dividend.

Small corporations – Consider investing in corporations with assets under $50 million. If you hold the stock for 5 years, there may not be any tax on capital gains. Speak to a tax advisor for details.

Opportunity zones – Capital gains on investments in designated Opportunity Zones can be deferred, reduced or potentially even eliminated under certain circumstances. There are a surprising number of such designated zones in every state, so the program is much more meaningful than many economic development programs in the past.

Independent Contractor or Employee?

There is increasing emphasis on classifying workers as employees, rather than independent contractors. California passed a new law, effective for 2020, that makes it very difficult to classify workers as independent contractors. Employers are required to pay a portion of your social security and Medicare taxes, workers compensation and other state taxes. They may also be required to extend health insurance and retirement benefits to you.

If you are in certain industries, though, the changes in employment classification may have a negative impact. If you are converted to employee status in the entertainment industry – writers and producers for example – you will no longer be able to deduct your business expenses, and you won’t be able to contribute to SEP IRAs or other high contribution retirement plans. California recently determined that gig economy drivers for such companies as Lyft and Uber can be independent contractors, so they will still be able to deduct expenses such as operating costs of their cars. It remains to be seen how this policy will be treated elsewhere.

Forming an S Corporation may avoid the negative impact of the new laws.

Retirement Plans

Make the maximum contributions to your retirement plans.

You can deduct contributions of $19,500 ($26,000 if you’re over 50) to your 401(k). Your employer can contribute as well, up to a total of employee and employer contributions of $57,000 ($63,500 if you are over 50). Contributions must be made as deductions from your salary. Consider contributing your year-end bonus to your 401(k) plan – but at least make sure you contribute enough to get the full amount of your employer’s matching program… It’s free money.

You may be able to deduct a contribution of up to $6,000 ($7,000 if you’re over 50) to a traditional IRA. You have until April 15 to make a contribution for the previous year, so you can see how it will affect your taxes before making the payment. There may be income limitations if you participate in a 401(k) or other qualified retirement plan with your employer. There is no longer an age restriction on traditional IRA contributions, as long as you have earned income.

Contributions to a ROTH IRA are not deductible, but you won’t pay tax on the investment income of the plan, if you wait until retirement age. There are restrictions on ROTH contributions based on your income, though. I have never seen a definitive answer to whether it’s better to choose a ROTH or a traditional IRA.

If you are in an income category where you are not eligible to deduct contributions to a traditional IRA or contribute to a ROTH IRA, consider a “back door ROTH.” You can make a non-deductible contribution to a traditional IRA, then convert it to a ROTH. It sounds a bit tricky, but it is still allowed. The contribution can be made over and above the $57,000 limit on qualified plans.

If you’re self-employed or have an S Corporation, you can contribute to a SEP IRA or a similar plan. You can deduct approximately 20% of your self-employment income, up to $57,000. The good news is that you can make your contribution all the way up to the filing deadline, including extensions, which gives you plenty of time to calculate your income. If you have an S Corp, you can also take advantage of a SEP IRA, but it must be paid by the corporation, and the amount is limited to 25% of the W-2 salary you receive from the corporation.

If you are self-employed or have an owner-operated business, you may find that a 401(k) plan offers you a better benefit than a SEP IRA. While the “employer” contribution is limited by your income (or by your W-2 salary from an S Corporation) you can still make an additional personal contribution of up to $19,500, or $26,000 if you are over 50. The plan needs to be set up before the start of the year.

If you have a successful corporation or partnership, you may consider a Defined Benefit retirement plan. There are important cost and other business issues involved in the decision, but you could potentially take a deduction of up to $230,000 – substantially more than a SEP IRA or 401(k). These plans work best for small businesses, as employees must be covered as well as owners and officers.

Generally speaking, don’t take money out of your traditional IRA or 401(k) plan if you are under 59 ? years old. There is a 10% penalty on top of the regular tax, and some states have an additional penalty. Corona-related distributions in 2020 receive favorable treatment, though. The 10% penalty is waived for withdrawals, and withdrawals may not be taxed if repaid within a 3 year period. Before you take an early withdrawal, though, remember that in 2020 you can borrow up to $100,000 from your 401(k) – but not your IRA - and it won’t be taxed if you repay it within 5 years. There are also penalties for early withdrawal from a ROTH, but only on the accumulated income, as your original contributions are not taxed a second time.

You can take a distribution from your IRA without a penalty if you are a first-time home buyer, if you make qualified tuition payments, and several other special situations. Remember that if you have a 401(k), and plan to make tuition payments, roll the 401(k) over into a traditional IRA first.

Consider rolling over your traditional IRA into a ROTH IRA. You will pay tax on the full amount when you roll it over, but if you expect to be in a low tax bracket this year, for any reason, this might be a good time to do it. Also, there is no required minimum distribution from a ROTH IRA after age 72. Be sure you understand how much tax you will pay on a conversion before you do it, though, because you can’t undo a conversion.

Minimum required distributions from your traditional IRA or 401(k) for those over age 72 (up from 70 ? previously) are waived for 2020. When required, though, there is a 50% tax if you don’t take a distribution. Don’t freak out if you miss the first one, though. They will generally abate the penalty as long as you act quickly to correct the oversight. Consider contributing your required minimum distribution (RMD) to a charity, to avoid paying tax on it.

Health Savings Account

You can contribute up to $3,550 ($7,100 for family coverage) to a Health Savings Account (HSA) for payment of qualified medical expenses. You must have a high deductible health plan to qualify. The result is that your out-of-pocket medical expenses are paid with tax free funds. Many employers offer such plans, but they are available for individuals as well. With some exceptions, you can carry forward unused balances to future years. Some states, including California, don’t recognize HSAs. If you don’t have an HSA, you really should look into it.

Charitable Donations

Charitable donations are a nice deduction, assuming your total deductions exceed the Standard Deduction. If you have shares of stock that have appreciated in value, consider donating the stock to charity. If you have owned the stock for more than one year, you can deduct the entire appreciated value of the stock, and avoid capital gains tax or Net Investment Income Tax (NIIT). The limit is 30% of your income, but any excess can be carried forward to future years.

Don’t contribute stock or other assets that have gone down in value. You are better to sell, and take the capital loss.

Gifts

You can make tax-free gifts of up to $15,000 ($30,000 for a married couple) per recipient. (Remember that gifts are not taxed to the recipient, but to the giver). Gifts in excess of this amount require filing a gift tax return, but you won’t actually pay tax until you go over your lifetime limit of $11,400,000.

Qualified payments for tuition or medical expenses are not considered a gift, as long as they are paid directly to the educational institution or the medical provider.

Consider contributing to a 529 savings plan. The contribution is not deductible, but income on the account is not taxable to the recipient if the funds are used for qualified education expenses. Contributions are subject to the gift tax rules, but you can spread a contribution over 5 years, so for example, a $75,000 payment will be considered $15,000 per year for 5 years. There can be differences between federal and state treatment of 529 plans.

Some people, in anticipation of their death, make gifts of real estate or other valuable property to family members. Be sure to speak with a tax advisor before you do this, as an inheritance could have a much more favorable tax benefit to your family member than a gift.

Avoid the “Kiddie Tax”

If your dependent children (under 19, or under 24 if they are full time students) have investment income over $2,200, it will be taxed at a much higher rate. So think carefully before you give them stocks to sell to pay for college.

Depreciation Opportunities

You can deduct 100% of qualifying asset purchases up to $1,000,000 (with phase-outs if your total purchases exceed $2.59 million) under Section 179. This is a tremendous incentive to buy capital assets which you would otherwise have to expense over several years. There are exclusions, but many of the excluded items are eligible for a 100% special depreciation allowance in the year of purchase. These are terrific deductions.

If you are planning to buy assets, buy them before year-end, and reduce your taxes for this year.

Filing Deadlines

Individual and C Corporation tax returns for 2020 are due on April 15, 2021, but may be extended to October 15. Remember that it is an extension to file only, but taxes are still due on April 15. Form 1065 Partnership (including LLC) Returns are due on March 15 (September 15 with an extension), as are Form 1120S S Corporation returns. Single member LLCs do not file Form 1065, so they are due with individual returns on April 15.

There are severe penalties for late filing of partnership, LLC and S Corp returns. For personal returns, there is only a penalty if you owe money. There is a good chance the penalty can be abated if it is your first time filing late.

Form 1099-MISC and Form W-2 must be issued to employees and contractors, as well as to the IRS or Social Security Administration, by January 31. It’s a good idea to confirm all employee information and W-9 information before the end of the year. Remember that Form 1099-MISC must be issued to all individuals and partnerships to whom you paid over $600 during the year. There are penalties for not filing these forms.

Estimated Payments

The theory is that we are supposed to pay our taxes as we earn the income. This is easy when your employer withholds tax from every paycheck, but not so easy for people with self-employment, partnership, S Corp, rental or investment income. That’s where estimated payments come in.

Generally speaking, in order to avoid a penalty, you are required to pay either 90% of this year’s tax by January 15, or 100% of last year’s tax (or 110% if your income is high). There is a quarterly schedule of payment dates, but it would be a good idea to make a payment before the end of the year if you expect to have a high tax bill. The penalty is not huge, but why pay a penalty when you can avoid it?

State and Local Taxes:

State and local taxing authorities have estimated payment requirements, too.

Pay attention to special requirements in your state or city. Common items to consider in California, for example, are:

LLC Minimum Tax and Fees – California LLC and Corporation minimum tax of $800 for 2021 is due by April 15, 2021. Additional fees for LLCs with higher revenues are due by June 15. There are underpayment penalties.

Los Angeles Business Tax – If you are doing business in the City of LA, you need to apply for a Business License before February 28, 2021, and renew it annually. Tax rates are low, and there is a fairly high threshold before you pay any tax, but penalties can be an unpleasant surprise if you don’t register. The tax applies not only to sole proprietors, corporations, partnerships and LLCs, but also to anyone who files a return with 1099 income on Schedule C or rental income on Schedule E.

Business Issues – Sole Proprietors, Corporations and Partnerships

There are many issues specific to business entities:

Deduction of Expenses:

Unreimbursed expenses that are not deductible for an employee can still be deducted if you change your status to independent contractor or S Corporation (see discussion below).

Keep Records:

It is important to keep documentation of your income and expenses. Especially expenses. Most people have never been audited, so it is easy to be undisciplined about documentation, but finding supporting documents 2 or 3 years after the fact can be a nightmare, and deductions may be disallowed.

 A particular area of concern is auto mileage. The IRS requires a contemporaneous mileage log, and they will not accept estimates, no matter how reasonable they may be. There are apps for business mileage. Get one and use it – it may save you a lot of money.

Independent Contractors or Employees – This is Important:

There is increasing scrutiny of the classification of workers as employees or independent contractors. When an employer treats a worker as an employee, they are required to pay 7.65% social security and Medicare taxes, in addition to state unemployment, workers compensation and other taxes. This is not required for independent contractors, so there is a significant difference in the cost to the employer, and to potential benefits available to workers, such as participation in health care and retirement plans.

On the other side, while many workers are negatively impacted by the independent contractor classification, others find significant benefits. Highly paid contractors can deduct their business expenses (which are not deductible by employees), make substantial contributions to SEP IRA retirement plans or individual 401(k)s, and deduct their health insurance premiums.

States have very specific rules to protect workers from employer abuse of the independent contractor classification, and in 2020, California passed a law that significantly limits the use of that status. Gig economy companies such as Uber and Lyft have recently been exempted from the new law.

It is still unclear whether a worker who would otherwise be an employee can provide services through an S Corporation.

If you use independent contractors, you should speak with your attorney. You may feel you need to change their status to employee. This may increase your costs substantially, so you will need to plan for it.

Qualified Business Income Deduction (QBI)

There is a potential deduction on your personal tax return of up to 20% of your Qualified Business Income, or income from a trade or business. This applies to income from a sole proprietor as well as a partner with pass-through income from a partnership or a shareholder with pass-through income from an S Corporation. It also applies to REIT dividends, as mentioned previously.

If your income (excluding capital gains and losses) is under $163,300 ($326,600 if you are married) you will be eligible for the full 20% deduction. The benefit phases out, however, so that there is no deduction when your income reaches $213,300 (or $426,600 if you are married). There are exceptions, though, and this is where planning can make a big difference.

If you are in a Specified Service Trade or Business (SSTB), you can’t get any benefit from the QBI deduction after you pass the phase-out income range. SSTBs include businesses related to health, law, accounting, consulting, performing arts and others. Engineering and architecture are specifically excluded from this group, and are eligible for further deductions, as discussed below.

If your business pays W-2 wages, and you are not a SSTB, then you can take a QBI deduction of up to 50% of wages paid, up to the 20% maximum. Alternatively, you can use 25% of wages and 2.5% of the undepreciated cost of property used in your business. This also applies to your share of pass-through income, wages and qualified property from a partnership or S Corporation.

Important planning point – As a shareholder of an S Corporation, you are required to pay yourself a reasonable W-2 salary, and this counts toward the QBI deduction. So, if your income exceeds the threshold, and you don’t have any employees, you should consider forming an S Corporation. See a more thorough discussion in another article on my tax blog.

Net Operating Losses (NOL):

NOL rules introduced in 2018 have been retracted in the wake of the Corona pandemic. NOLs can be carried back as far as 5 years, and the limitation on loss carryforwards has been lifted. An election is required if you want to to waive carryback of losses and carry them forward to future years.

The limitation on trade or business losses of $250,000 ($500,000 if married filing jointly) has been temporarily discontinued.

Rules for S Corps and Partnerships:

There are very specific rules related to S Corps and Partnerships, and now is a perfect time to be sure you in compliance before year-end. It would be a shame to lose out on the tax benefits of these business entities

Check your state’s registration requirements. California corporations and LLCs must file a statement of information every one or two years. The risk is that your entity will be suspended, and it’s annoying and expensive to correct.

S Corp W-2 Salary – IMPORTANT – If you have a Subchapter S Corporation, you are an employee. You pay employment taxes on your W-2 salary, but not on the net income of the corporation. You are required to pay yourself a “reasonable salary”, and issue yourself a W-2 as an employee. Issuing yourself a 1099 is not a substitute.

-       There is an incentive to pay a lower salary to reduce employment taxes, but the “reasonable salary” requirement is there to prevent abuse.

-       On the other side, SEP IRA and 401(k) contributions are limited to 25% of your W-2 salary. The more you want to contribute, the higher your W-2 salary must be.

-       As discussed above, your W-2 salary can be used to take advantage of the Qualified Business Income deduction if your income is over the phase-out range.

Retirement plans – As discussed above, there are opportunities for S Corp shareholders and partners in partnerships and LLCs to make substantial tax-deferred contributions to SEP and other retirement plans. The contributions are a percentage of your partnership income or your S Corp W-2 salary. It is important to remember that the retirement plans MUST be in the name of the S Corp or the partnership. Individual shareholders and partners cannot have their own individual SEP plans.

Health Insurance – Your health insurance payments may be deductible on your personal return if you are a shareholder in an S Corp or a partner in a partnership or LLC, and you meet certain requirements. Remember, though, that the payments must be made by the corporation or LLC – or reimbursed if you make the payments yourself. Payments for your health insurance made by your S Corp must be included as compensation on your W-2, but are not subject to payroll taxes. Make this clear to your payroll processing company. Payments by your partnership or LLC are treated as distributions. If you have a single member LLC, you can make payments from your business or personal account.

Do you need your LLC or S Corp? – Are you getting any real benefit from it? If you are in a state that has a minimum LLC or S Corp tax, you may be paying for something you don’t really need. California’s minimum tax is $800, and you’re also paying for a relatively expensive tax return. If limited liability is a big concern, consider buying insurance that offers appropriate protection. Closing the LLC or S Corp before year-end won’t reduce your 2020 tax bill, but it will cut future costs… See an article I posted previously on my tax blog.

I would be pleased to discuss your tax planning issues.