The outcomes of two runoff elections in Georgia that are scheduled for Jan. 5 will determine the balance of power in the U.S. Senate, and may also have an impact on the kind of tax planning that accountants should be advising their clients to do.
President-elect Joe Biden’s ability to pass his tax proposals into law will depend on whether Democrats control the Senate, given the party's shrinking margin of control in the House. If Democratic challengers Jon Ossoff and Raphael Warnock manage to beat Republican incumbents David Perdue and Kelly Loeffler in January, the Senate would be evenly split next year, with Vice president-elect Kamala Harris able to cast the deciding vote to break any ties over possible tax legislation if the Democrats used a budget reconciliation maneuver to overcome a Republican filibuster.
“There’s a little bit of frustration because there’s still a level of uncertainty,” said Jim Guarino, a managing director at Top 100 Firm Baker Newman Noyes. “The reason why I say that, not so much with regard to President-elect Biden, but because of the fact that we still are unsettled at the Senate level and we’re really not going to have an answer until the first week of January. What’s a little troublesome is if we knew for sure whether or not there was going to be traction with regard to President-elect Biden’s proposals.”
The majority of his proposals would likely find their way into Democrats’ tax legislation, but the prospects of passing any tax legislation will depend on whether Democrats can push them through the Senate and a narrowly divided House. That puts accountants into a bind when it comes to predicting tax strategies.
“I think we would be much more certain and confident with regard to our actions, but the reality is if the Republicans continue to retain control over the Senate as a result of the Georgia runoff in January, many of his proposals may not get through,” said Guarino. “That’s not to say that everything will be squashed, but maybe a significant amount of them may not make their way through, and some of the planning steps that we’ve taken in December may not have been necessary. The problem with that scenario is we’re not going to know until Jan. 5 or Jan. 6, and the clock strikes midnight on Dec. 31.”
Jonah Gruda, a partner and leader of the private client services group at Top 100 Firm Mazars USA, believes clients should try to take advantage of the low tax rates in the meantime, assuming they might go up for high-income taxpayers under a Biden administration.
“Some of the things we’ve been seeing from the Democrats is lifting the capital gains rates to as high as the maximum ordinary rate for taxpayers making over a million dollars,” he said. “That almost doubles the current rate, from 20 percent to 37 percent. Another proposal would bring that up to 39.6 percent. I think that’s where we’re probably headed is the highest marginal rate would be 39.6 percent and the capital gains rates would be tied to that.”
The Supreme Court’s decision on the latest case challenging the constitutionality of the Affordable Care Act could add another wrinkle to tax planning for next year.
“Depending on what happens in the Supreme Court with the ACA, what everyone knows as the Obamacare tax, the net investment income tax, that would potentially add a 3.8 percent surcharge, which means, if this all goes through ... that means capital gains and qualified dividends could be as high as 43.4 percent, which would mean your tax rate on capital gains and qualified dividends would potentially be more than your effective rate on your wages,” said Gruda. “So what does that mean for planning purposes?”
Some clients may want to sell some of their securities and assets this year instead of waiting until a future year in case they're worried about tax rates, especially for capital gains taxes, going up in a Biden administration.
“One of the things I talk to clients about is how long are they planning to hold the asset? What do you think the future appreciation is going to be? If we think they want to sell things and generate liquidity in 2021 and have some flexibility, maybe it makes sense to sell that before the end of the year to lock in the lower rates,” said Gruda. “On the other hand, if you’re bullish on a particular asset, maybe selling prematurely is not really the best course of action because you lose the ability for that appreciation to get captured. It really just depends on what the individual goals are for the taxpayers. If you’re planning on entering a transaction in the new year, you may just want to preempt it now because we know the rates are lower.”
Guarino and his colleagues have been fielding calls from clients asking about capital gains rates going up, even though most taxpayers aren’t in danger of seeing those rise under a Biden administration.
“The irony to all of this, as my colleague admitted, is that these folks weren’t anywhere near the $1 million taxable income threshold, and yet a little information is dangerous,” said Guarino. “I guess all they heard was that capital gains rates could go from currently a high of 20 percent to as much as 39.6 percent and they were ready to jump off the cliff and start selling out positions between now and the end of the year. My colleague said, ‘Hey, listen, I’m not going to tell you what to do from an investment standpoint, but if all you’re doing this for is driven by a tax motivation only, then I’d really caution you to put the brakes on and think this through, because unless there’s something happening in your world that I’m not aware of, the last time I checked you were nowhere near the taxable income threshold that President-elect Biden has proposed.’”
Like Gruda, he has been advising clients to accelerate some of their transactions for this year, just in case the tax rates do go up. “One of the things that we're really advocating is being aware of and taking advantage of whatever current tax bracket that you’re in,” said Guarino. “Right now there are seven tax brackets, but there’s a couple of important inflection points within those tax brackets. Essentially the tax brackets go from 10 to 12 percent, and there’s this big spike from 12 percent to 22 percent, and from there we’ve got a 22 to 24 percent bracket. Then there’s another spike that jumps to 32 percent.”
For those who are on the verge of entering another tax bracket, he is advising them to claim any potential additional income from stock options and bonuses this year, rather than next year.
“Not all of us have that great of a control over our compensation,” Guarino added. “If there are potential bonuses that we can pick up this year, we’re going to flip that switch. But the two areas that I’m finding give us the most flexibility is with regard to stock option planning, whether it’s nonqualified stock options or some other deferred compensation that we can position ourselves to receive this year.”
Gruda has also been advising his clients to accelerate some of their income. “If you know the Biden plan is going to come into effect in the New Year, maybe you’ll accelerate income in 2020 and defer expenses until 2021, which is counterintuitive to what the traditional planning used to be,” he said. “It used to be to defer income and accelerate expenses. Now if I know my income is going to be taxed at higher rates, let me accrue that income and accelerate income into a tax bracket where I know the rate is going to be lower and defer expenses until future years when I know those expenses are going to be worth more in terms of tax savings.”
High regard for Roths
Roth individual retirement accounts can help with tax planning. “Really the creme de la creme is taking advantage of a Roth conversion,” said Guarino. “That really does a couple of good things. It allows us to fill up that 24 percent tax bucket, and maybe more importantly it takes some deferred retirement plan income that we otherwise would have to recognize somewhere down the road in the future and allows us to report that income this year. We’re making a bet. We’re looking into the crystal ball and saying we’re in a really low tax bracket this year, albeit a 24 percent tax bracket. Our gut feeling is that somewhere in the future, when we start taking our distributions from these retirement plans, we’re probably going to be in a higher tax bracket, so we’re going to leverage the lower rates this year and hopefully the time value of money doesn’t work against us.”
Gruda has also been advising clients to do Roth IRA conversions. “A lot of us do have 401(k)s or IRAs,” he said. “One of the things we might want to consider now is if you do think taxes are going to change, maybe not this year, maybe not next year, maybe you will consider rolling over your 401(k) into a Roth because let’s take in the lower tax bracket now, as opposed to waiting until later on to take that money out at higher rates. Maybe you want to start investing in those Roth products now rather than invest in your 401(k)s and your traditional IRAs now. A lot of tax policy and politics relates to what your philosophical outlook on life is. ... But those are some things you can do now.”
Many taxpayers this year won’t have the ability to take advantage of these strategies, especially if they have lost their jobs or businesses or worry they might lose them in the months ahead. For those who have been collecting unemployment benefits, accountants should make them aware that those benefits are taxable.
"Folks don't realize that it’s taxable, so come the end of the year they’re going to receive a statement that reports the amount of unemployment compensation benefits that that they’ve received," said Guarino. "Unfortunately they may not have had any taxes paid in, so those folks who may not be in the high-income taxpayer bracket are going to have tax reporting issues. We’ve tried to alert them through blogs and emails. But I think that’s one of the bigger concerns is that they could be exposed to potential tax penalties because they just haven’t paid enough taxes in, or more importantly when they go to file their tax return in April and their advisor says you owe $2,500, they’re not going to have the funds to pay those taxes.”
For those with extra money to set aside, he advises them to consider using some of it for charitable giving vehicles such as donor-advised funds. “It’s kind of a one-two punch,” said Guarino. “On one hand, we’re picking up additional income from the Roth conversion and then we’re utilizing a very substantial charitable contribution to help offset that income for this year.”
Estate taxes could also be a concern for some clients. The estate tax exemption in the Tax Cuts and Jobs Act of 2017 means only a few estates would be facing those taxes -- those with estates of over $11.18 million for single taxpayers and over $22.36 million for married couples, indexed for inflation. But there may be some complications for other taxpayers if the law changes under the new administration.
“We have this issue with step up in basis,” said Gruda. “Under current law, if you or I should pass away, any assets that we hold within our estate get stepped up to the current fair value at death, so if you hold IBM stock or a piece of property and it’s worth a million dollars when you die, the new basis of that asset is a million dollars. However, one of the proposals is that step up is eliminated, which is a big deal because if you get a step up in basis and you sell an asset to generate liquidity that you inherit, you wouldn’t have any gain on that. But now potentially you would if that step up in basis goes away.”
He has been talking with some of his clients about estate planning and trusts. “It depends on whether you want to try to keep that wealth in the family, or you want it to go to charity, or you’re fine with some of that wealth going back to the government in the form of taxes,” said Gruda. “It just depends on what your worldview is. We’re talking about what the potential options are, whether you should set up trusts now with the remaining exemptions that the Tax Cuts and Jobs Act afforded us, what assets would be key assets in an estate planning scenario, and what should happen if you wait and those exemptions get brought down to earlier years when it was $3.5 million. What does that do with your taxable estate now?”
The priority for Congress in the months ahead probably won’t be tax legislation as much as COVID-19 relief for the people and businesses struggling to cope with the pandemic, as well as aid for state and local governments and health care providers. That may be something that enough Republicans and Democrats can agree on, whatever the outcome of the runoff elections in January turn out to be. In the meantime, there are some steps that taxpayers can take before the end of the year.
“One of the things that I’ve been sharing with my clients recently is that time is of the essence,” said Guarino. “Our job as advisors is to bestow on our clients enough education and knowledge to give them an opportunity to make an educated decision. We’re not going to tell them what to do. We’re going to give them the tools and knowledge that they need to make an educated decision. The one thing we always say to them is you never want to be in a situation where all that you’re stating is ‘woulda, coulda and shoulda.’ You don’t want to be in that position. It’s one thing to be wrong, but at least be wrong because you were given information and you just made a bad choice.”
He believes it’s important for clients to make some decisions before the end of the year. “For some of the things that they may want to do, they can’t wait until Dec. 31,” said Guarino. “If it’s contributing to a donor-advised fund, if they’re trying to make a substantial charitable donation, some of the administrators are closing their doors midway through December, so if they haven’t already started to think about what they want to make in the form of a charitable donation to a donor-advised fund, they’d better make that decision pretty soon. ... The same holds true if they’re doing a Roth conversion. They're going to have to talk to their investment folks to get that ball rolling and not wait until the bitter end.”
