2021 may go down as one of the most extraordinary years for tax changes in a generation. This is the final year for a few rules enacted as part of the Tax Cuts and Jobs Act (TCJA), which sets up looming tax changes for businesses starting Jan. 1, 2022. Most of the short-term initiatives designed to help businesses get through the COVID-19 pandemic are set to expire by the end of the year. On top of those known changes, the Biden administration has announced a variety of proposals that, if enacted, could have a significant impact on businesses and higher-income individuals for years to come.
How can businesses and individual taxpayers plan with so much potential change facing them in the next 6-18 months? The short answer is, “very carefully.” But to elaborate on that topic, the key lies in separating out actual responses to laws that are already in place and planning potential responses to proposals that may become law.
Midyear planning in a year of change
By now, businesses have become accustomed to hearing tax advisors talk about the importance of year-end planning, and it probably seems like that discussion starts earlier every year. But midyear planning this year is critical for three reasons:
- Some important tax rules will change at the end of 2021 (barring legislative action to extend them), and businesses can’t afford to wait until December to prepare for those changes.
- Some COVID-19 relief programs will expire this year and businesses could reap significant savings if they take advantage of them in a timely manner.
- Some new tax proposals could be enacted with effective dates in this year or next year, and each business needs to understand the potential impact of those changes in order to minimize taxes.
Provisions set to expire without legislative action
The TCJA made big headlines with rate reductions for individuals and businesses and a host of other provisions that were hailed as business-friendly. However, the TCJA did include a few revenue-raising provisions to offset the cost of tax cuts. Two specific revenue raisers will become an issue after Dec. 31, 2021, unless Congress acts to change them. The changes will affect the deduction for research and development (R&D) expenses and limitations on business interest expense deductions. Here’s a quick summary of each:
- R&D expenses: Up to this point, businesses have had significant flexibility in determining whether they deduct R&D costs as current-year expenses or capitalize them and amortize them over a number of years. Starting in 2022, R&D costs must be capitalized. U.S.-based costs will be amortized over five years, while costs incurred outside the U.S. will be subject to a 15-year amortization period. This significant change will require taxpayers to track R&D costs with a level of specificity that was not required in the past. Unfortunately, the cash flow implications of this change could be substantial for businesses with even modest R&D expenditures. Adding to the uncertainty, there’s bipartisan support in Congress to repeal this provision before it becomes effective. However, the change raises a significant amount of revenue for the government that would be hard to replace. Taxpayers may need to start working now to create a system that can track these costs and consider implications to their cash flow budgets. Given the uncertainty of legislative action, businesses should consider preparing now to document these costs in a manner that complies with the new rules.
- Business interest expense limitations: A change to business interest expense rules will also affect cash flows beginning in January 2022. As of January 1, depreciation, amortization, and depletion will no longer be added back to calculate adjusted taxable income (ATI). Businesses can deduct an amount of annual interest expense equal to 30% of ATI. This means that the change will reduce the maximum amount of interest that is deductible by 30% of annual depreciation, amortization, and depletion. Ultimately, this will result in many businesses seeing more of their interest expenses disallowed. It’s also possible for Congress to take action before this change takes effect. However, modifying this change has gotten considerably less attention than the R&D changes, so the likelihood of congressional action is uncertain.
Maximizing state and local tax deductions
For a little bit of possible good news, there are efforts taking shape in many states to help mitigate the limit on state and local tax (SALT) deductions for individuals that was imposed under the TCJA. More than a dozen states have passed laws that impose state taxes on passthrough entities that would qualify for deductions from the income of the entity before it passes through to the individual owners. It may sound somewhat counterintuitive to celebrate entity-level taxes as “good news,” but this policy does have the capacity to lower the overall tax liability of passthrough business owners. This works by shifting the state tax payment to the entity, where it can be fully deducted, rather than at the passthrough- owner level where the annual $10,000 SALT deduction limit is imposed.
Early guidance from the IRS describing the type of state entity-level taxes that will be respected is short on specifics. Thus, it is unclear to what extent the IRS plans to challenge these arrangements in the future, depending on the final details of the new state regimes. As more states enact similar laws, it’s possible that the IRS guidance will get more specific and that some state laws may not meet all requirements that the IRS prescribes.
Even assuming that the IRS will respect the entity-level taxes, there are still complicated issues to be considered. Each applicable state regime will need to be examined to determine the impact on the entity and its passthrough owners since each state tax system does not perfectly coordinate with other states. In a worst-case scenario, an entity could elect into a state tax regime to obtain entity-level federal tax deductions, but its passthrough owners might still be subject to state taxes on passthrough income. That would, in effect, result in double taxation by states. Moving forward, businesses should absolutely consider whether these new state tax regimes will be beneficial to them. However, it will be important to also consider whether the state regimes match the federal guidelines and the ultimate impact to passthrough owners.
COVID-19-related tax relief
The urgency, timing, and extraordinary circumstances of the pandemic drove the implementation of an exceptional variety of relief programs. Most of those programs focused more on loans, grants, and payroll taxes, as those types of relief typically get money into the hands of affected businesses more quickly. Payroll tax adjustments have been significant in providing immediate relief because businesses are used to making those deposits approximately every two weeks.
Opportunities continue to exist to claim COVID-19-related payroll tax credits in prior calendar quarters retroactively. However, as businesses reach the middle of 2021, it’s important to reevaluate the possibility that their activities may qualify for some extremely valuable credits. When looking at new payroll tax credit opportunities, businesses should focus on recent changes to these programs and broader pandemic trends. Here are some immediate areas for consideration:
- Employee retention credit: The employee retention credit provides a potentially significant opportunity for businesses, but it has been somewhat overshadowed by the more widely publicized Paycheck Protection Program (PPP). The credit was originally enacted in March 2020 and has been modified several times. A qualifying business with 100 employees could earn a maximum retention credit of up to $2.8 million in 2021 (or $7,000 per quarter per employee), but the benefits can grow even larger. When assessing eligibility for the employee retention credit, there are several items worth reviewing today, including:
- Meeting the gross receipts threshold: An employer claiming the retention credit must establish its eligibility based on one of two main tests: either a qualifying reduction in gross receipts or a partial or full shutdown of the business due to a governmental order. As most COVID-19-related government restrictions have lapsed, the primary focus of eligibility shifts to a gross receipts decline. During 2021, a business is eligible for the retention credit if it experiences a 20% or greater decline in quarterly gross receipts when comparing the current quarter to the comparable quarter in 2019 (a business can also qualify in a current quarter if the prior quarter experienced a 20% decline). A crucial detail is that the decline in gross receipts does not need to be directly attributable to the COVID-19 pandemic. Any drop in gross receipts that meets the threshold will qualify. As a result, businesses may find themselves eligible as a consequence of either supply chain issues or staffing difficulties that negatively impact gross receipts. For this purpose, gross receipts are calculated on a tax basis. Taxpayers have a lot of flexibility in their methods of recognizing gross receipts for tax purposes. With this in mind, revisiting tax accounting methods for revenue could prove advantageous and help businesses to qualify for the employee retention credit.
- Startup eligibility: Startup businesses that were locked out in prior periods because they didn’t have pre-pandemic revenues for comparison may become eligible for the credit in the third quarter of 2021. The new eligibility criteria applies to businesses that: (1) began operations after February 15, 2020, (2) do not meet the other eligibility criteria (gross receipts decline or partial/full shutdown), and (3) have annualized gross receipts of $1 million or less.
- Family and sick leave credits: Federal government requirements that employers provide enhanced paid sick and paid family leaves ended as of Dec. 31, 2020. However, payroll tax credits are still available in 2021 for certain employers who choose to provide these benefits to their employees. To determine eligibility, an employer must evaluate whether it would have been required to provide the paid leave if the mandate had been extended. The qualifying paid leave was also expanded to include sick leave beginning on April 1, 2021 for an employee to get the COVID-19 vaccine or to recover from side effects resulting from the vaccine.
Rarely have employers been called upon to keep up with such a flood of information about health and safety requirements necessary to operate their business, as well as the loan programs, grants, and tax relief related to help support them. To catch up on all these aid programs, there are two important things to remember:
- Businesses that failed to claim some of the tax credit programs on their original returns may still be able to amend prior quarterly filings to claim them.
- Businesses that filed for COVID-19 relief under any of the programs available should consider reviewing calculations and filings to make sure that eligibility is calculated accurately and properly documented. It’s likely that audits will happen in the future as the government attempts to measure compliance with the requirements of the programs. Contemporaneous documentation is often the best form of support and is expected to be very helpful in the future.
Proposals under discussion for the rest of this year
Now take a few moments to consider what might happen throughout the rest of 2021. President Biden has released some relatively specific tax proposals, such as an increase in the corporate tax rate from 21% to 28% and an increase in the top individual rate from 37% to 39.6%. His proposed increase on capital gains taxes to that same 39.6% rate for taxpayers with over $400,000 in income has garnered significant press, but there are still many questions that remain unanswered. Please see our analyses of the full Biden proposals and the international proposals for additional details.
To help understand what the remainder of the year might look like, it may be helpful to think back to the first year of the Trump administration in 2017. At this time four years ago, President Trump had issued an outline of a plan pushing for lower taxes, and he had the support in Congress to get it enacted. However, negotiations in Congress still took months and were only concluded at the very end of the calendar year. This year, it’s safe to say that the president has made his position on tax increases fairly clear, and it appears that he has some degree of support from the Democratic majority in Congress. At this point, it’s expected that those factors will result in some meaningful tax law changes before the end of the year. Beyond that, the major questions remain unanswered.
Business structures and accounting methods
After the TCJA enacted certain potentially advantageous changes — such as the 20% qualified business income deduction and the lower corporate rate — one of the most frequently asked questions was, “Should I change the entity structure of my business?” In short, the answer for most businesses was that slight tax advantages should not be wagging the choice-of-entity dog. When fully considering an entity-choice analysis, it’s critical to balance short-term tax costs on operations with long-term tax impacts on things like a future sale transaction, succession planning, and other tax and operating costs. Law changes that might make a tax structure seem more attractive now are always subject to change, so immediate reactions to a law change can sometimes backfire. Until details are available on whatever proposals eventually become law, an entity change is unlikely to be a good idea unless it’s driven by non-tax objectives.
Accounting methods, on the other hand, should be part of every tax planning discussion. Depending on the item, accounting method planning must be performed at different times of the year — some items must be addressed at the start of the year, others during the year, and still others at year-end — and some aren’t addressed until the tax return is filed. Accounting methods can significantly impact the amount of revenue and expenses that are recognized in a year for tax purposes. When rates are expected to increase, they can result in a permanent tax savings for some businesses.
So, what should businesses do now?
Right now, the key is to identify a strategy. Businesses need to be clear about where they’re heading and outline the inventory of relevant tax planning topics. That will enable them to react quickly to potential late-year tax law changes.
Once a business has a clear picture of its strategy, it can “plan to plan” by taking steps like:
- Analyzing and understanding the elements of current proposals that could affect the business if enacted. It’s not necessarily about planning for every possibility so much as identifying those potential changes that would have the most significant impact on operations, then thinking through possible responses that could minimize the damage.
- Establishing a timeline for implementing changes related to different options so affected departments know what steps must be taken to react in time.
- Building a plan of possibilities and remaining flexible so that the plan can be adapted as the environment changes.
Final thoughts: Taxes are unlikely to get less complicated in 2021
While it’s hard to make predictions about the future of U.S. taxes, it seems pretty certain that taxes will not be getting any less complicated between now and the end of 2021. Given the likely expiration of certain beneficial provisions and the possible increases that could be enacted, it’s possible that there has never been a more important year for midyear tax planning. For more information on how these possible changes in the tax law could affect your business, reach out to a Plante Moran advisor — we’re here to help.
