The COVID-19 pandemic has thrown a variety of obstacles into individual and business tax planning for the past two years, and now add a pair of potential federal legislative packages — either of which could be settled, passed, and signed into law before the end of this year.

While we wait to see which provisions survive in the proposed budget reconciliation bill and the separate Build Back Better Act (BBBA) — which was passed by Congress but still awaits the Senate — there are a few year-end strategies to explore that might reduce your tax liability for 2021.

FOR INDIVIDUALS

Accelerate and defer with care

One of the most reliable year-end tactics for reducing taxes is to accelerate your deductible expenses and defer your income. For example, self-employed individuals who use cash-basis accounting can delay invoices until late December and shift the planned purchase of equipment or the payment of estimated state income taxes from early 2022 to this year.

This technique has always carried a caveat: Avoid pursuing it if you expect to be in a higher tax bracket the following year. Potential provisions in the BBBA also could make it advisable for certain taxpayers to reverse the strategy for 2021 — that is, accelerate income and defer deductible expenses.

The current negotiated version of the BBBA would impose a “surtax” of 5% on modified adjusted gross income (MAGI) that exceeds $10 million, with an additional 3% on income of more than $25 million. As a result, the highest earners could pay a 45% federal marginal income tax on wages and business income (the current 37% income tax rate plus 8%). It could be even higher when combined with the net investment income tax, which might be expanded to include active business income for pass-through entities.

Keep in mind there’s also a proposal to temporarily increase the $10,000 cap on the state and local tax deduction to $80,000. Individuals in high-tax states should consider whether there may be an advantage to accelerating a 2022 property or estimated state income tax payment into 2021, or whether the deduction might be more valuable next year, particularly if they’ll face a higher effective tax rate.

Leverage your losses

Taxpayers with substantial capital gains in 2021 might benefit from “harvesting” their losses before year-end. Capital losses can be used to offset capital gains, and up to $3,000 ($1,500 for married persons filing separately) of excess losses (those that exceed the gains for the year) can be applied against ordinary income. Any remaining losses can be carried forward indefinitely.

But beware of the wash-sale rule. Generally, it prohibits the deduction of a loss if “substantially identical” investments are acquired within 30 days before or after the date of the sale.

Taxpayers who itemize deductions could compound their tax benefits by donating the proceeds from the sale of a depreciated investment to a charity. They can offset realized gains and claim a charitable contribution deduction for the donation.

Satisfy charitable inclinations

For 2021, charitable contributions can reduce taxes for itemizers and those who don’t. Taxpayers who take the standard deduction can claim an above-the-line deduction of $300 ($600 for married couples filing jointly) for cash contributions to qualified charitable organizations.

The adjusted gross income limit for cash donations is 100% for 2021, but it’s scheduled to return to 60% for 2022. That means you could offset your taxable income with charitable contributions this year. But remember that donations to donor-advised funds and private foundations don’t qualify.

Taxpayers who don’t generally itemize can benefit by “bunching” charitable contributions. In other words, delaying or accelerating contributions into a tax year to exceed the standard deduction and claim itemized deductions. For example, if you usually make your donations at the end of the year, you could bunch donations in alternative years — for example, donate in January and December 2022, and then in January and December 2024.

Retired taxpayers who are age 70½ and older can reduce their taxable income by making qualified charitable contributions of up to $100,000 from their non-Roth IRAs. Retired or not, individuals age 72 and older can use such contributions to satisfy their annual required minimum distributions (RMDs). Note that RMDs were suspended for 2020 but are effective for 2021.

So long as the assets would be considered long-term if they were sold, donations of appreciated assets offer a double-barreled tax benefit. You avoid the capital gains tax on the appreciation and can deduct the asset’s fair market value as of the date of the gift.

Convert traditional IRAs to Roth IRAs

As in 2020, when many taxpayers saw lower than typical income, 2021 could be a smart time to convert funds in traditional pre-tax IRAs to an after-tax Roth IRA. Roth IRAs have no RMDs, and distributions are tax-free.

You will have to pay income tax on the converted funds, but it’s better to do so while subject to lower tax rates. Similarly, if you convert securities that have dropped in value, your tax may well be lower now than down the road — and any subsequent appreciation while in the Roth IRA will be tax-free.

It’s worth noting that President Biden had proposed including a provision in the BBBA that would limit the ability of wealthy individuals to engage in Roth conversions. There was back-and-forth with respect to these provisions, and the latest version of the House bill includes only some of those restrictions. Whether these provisions will survive negotiations remains to be seen, but the proposal could be a harbinger of future proposed restrictions.

FOR BUSINESSES

Research and experimentation

Section 174 research and experimental (R&E) expenditures generally refer to research and development costs in the experimental or laboratory sense. They include costs related to activities intended to uncover information that would eliminate uncertainty about the development or improvement of a product.

Currently, businesses can deduct R&E expenditures in the year they’re incurred or paid. Alternatively, they can capitalize and amortize the costs over at least five years. Software development costs also can be immediately expensed, amortized over five years from the date of completion or amortized over three years from the date the software is placed in service.

However, under the Tax Cuts and Jobs Act (TCJA), that tax treatment is scheduled to expire after 2021. Beginning next year, you can’t deduct R&E costs in the year incurred. Instead, you must amortize such expenses incurred in the United States over five years and expenses incurred outside the country over 15 years. In addition, the TCJA requires that software development costs be treated as Sec. 174 expenses.

The BBBA may include a provision that delays the capitalization and amortization requirements to 2026, but it’s far from a sure thing. You might consider accelerating research expenses into 2021 to maximize your deductions and reduce the amount you may need to begin to capitalize starting next year.

Income and expense timing 

Accelerating expenses into the current tax year and deferring income until the next year is a tried-and-true tax reduction strategy for businesses that use cash-basis accounting. These businesses might, for example, delay billing until later in December than they usually do, stock up on supplies and expedite bonus payments.

But the strategy is advised only for businesses that expect to be in the same or a lower tax bracket the following year — and you may expect greater profits in 2022, as the pandemic hopefully winds down. If that’s the case, your deductions could be worth more next year, so you’d want to delay expenses while accelerating your collection of income. Moreover, under some proposed provisions in the BBBA, certain businesses may find themselves facing higher tax rates in 2022.

For example, the BBBA may expand the net investment income tax (NIIT) to include active business income from pass-through businesses. The owners of pass-through businesses — who report their business income on their individual income tax returns — also could be subject to a new 5% “surtax” on modified adjusted gross income (MAGI) that exceeds $10 million, with an additional 3% on income of more than $25 million.

Capital assets

The traditional approach of making capital purchases before year-end remains effective for reducing taxes in 2021, bearing in mind the timing issues discussed above. Businesses can deduct 100% of the cost of new and used (subject to certain conditions) qualified property in the year the property is placed in service.

You can take advantage of this bonus depreciation by purchasing computer systems, software, vehicles, machinery, equipment, and office furniture, among other items. Bonus depreciation also is available for qualified improvement property (generally, interior improvements to nonresidential real property) placed in service this year. Special rules apply to property with a longer production period.

Of course, if you face higher tax rates going forward, depreciation deductions would be worth more in the future. The good news is that you can purchase qualifying property before year-end but wait until your tax filing deadline, including extensions, to determine the optimal approach.

You can also cut your taxes in 2021 with Sec. 179 expensing (deducting the entire cost). It’s available for several types of improvements to nonresidential real property, including roofs, HVAC, fire protection systems, alarm systems, and security systems.

The maximum deduction for 2021 is $1.05 million (the maximum deduction also is limited to the amount of income from business activity). The deduction begins phasing out on a dollar-for-dollar basis when qualifying property placed in service this year exceeds $2.62 million. Again, you needn’t decide whether to take the immediate deduction until filing time.

Business meals

Not every tax-cutting tactic has to be dry and dull. One temporary tax provision gives you an incentive to enjoy a little fun.

For 2021 and 2022, businesses can generally deduct 100% (compared with the normal 50%) of qualifying business meals. In addition to meals incurred at and provided by restaurants, qualifying expenses include those for company events, such as holiday parties. As many employees and customers return to the workplace for the first time after extended pandemic-related absences, a company celebration could reap both a tax break and a valuable chance to reconnect and re-engage.

Step into 2022 with caution

The strategies outlined here are subject to a mix of pros and cons, and it’s important to consider other possible scenarios based on the passage or failure of proposed legislation. Feel free to contact me or any KraftCPAs tax advisor for help as you explore options for your 2021 returns.

© 2021 Kraft CPAs PLLC

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