Now that the summer has unofficially ended, it's time to focus on the start of school, cooler days and taxes.
This Alert will preview select year-end tax planning opportunities to stimulate your thinking while providing enough time to effectively execute the most appropriate tax planning strategies for your personal or business situation.
It has now been almost two years (21 months to be exact) since President Trump signed into law the Tax Cuts and Jobs Act (TCJA)—the largest major tax reform in over three decades. The IRS continues to release guidance and update tax forms to incorporate new aspects of the law. With the first TCJA tax season behind us and the second tax year coming to an end in less than four months, we'll discuss and preview select tax planning opportunities and easy-to-deploy moves to cool off your personal and business tax bill for 2019.
Find Ways to Defer Income
If you expect to be in the same or lower tax bracket in 2020, it may be beneficial to employ the tried-and-true technique of deferring taxable income until next year. For example, if you own a business and use the cash method of accounting, you can wait until the end of the year to send out invoices to ensure you won't receive payments until 2020. If you are still working and do not own 5 percent or more of the business employing you, you can postpone required minimum distributions (RMDs) from your employer's qualified plan (e.g., 401(k)) until you retire. This "still working exception" does not apply to RMDs from IRAs or plans of employers where you no longer work. Another deferral strategy includes contributing up to $19,000 to a 401(k) in 2019 ($25,000 if you are age 50 or older). You can also postpone taxable income by accelerating some deductible expenses into 2019. This may be helpful if you're affected by unfavorable phaseout rules that reduce or eliminate various tax breaks (higher education tax credits, for example).
Take Advantage of Lower Tax Rates on Investment Income
Income from an investment held for more than one year is generally taxed at preferential capital gains rates. Those rates are zero percent, 15 percent and 20 percent for most investments. (Higher-income individuals may be subject to an additional 3.8 percent net investment income tax.) The rate that applies is determined by your taxable income. For example, the zero percent rate applies if your 2019 taxable income doesn't exceed $78,750 (for joint filers), $52,750 (for heads of household) or $39,375 (for other individuals). The 20 percent rate kicks in when taxable income exceeds $488,850 (for joint filers), $461,700 (for heads of household) or $434,550 (for other individuals).
If your taxable income hovers around these threshold amounts, there are ways to reduce your income to take advantage of a lower capital gains rate. For example, you could make deductible IRA contributions or reduce taxable wages by deferring bonuses or contributing to employer retirement plans. With proper planning, you may be able to qualify for the zero percent rate.
Gifting to Achieve Lower Rates
If your income is too high to benefit from the zero percent rate, consider gifting investments like appreciated stock or mutual fund shares to children or grandchildren. Chances are these individuals will be in the zero percent or 15 percent capital gains tax bracket. If they later sell the investments, any gain will be taxed at the lower rates, as long as you owned the investments for more than one year. This strategy has two noteworthy risks, however. First, there are gift tax consequences if you transfer assets worth over $15,000 during 2019 to a single recipient. Second, all children under age 18 and most children ages 18 to 23 who are full-time students are subject to the "kiddie tax" rules. The kiddie tax limits the opportunity for parents to take advantage of the zero percent capital gain rate by gifting appreciated property to their children, including college-age children. Please contact us for guidance in this complex area.
Take Advantage of Your Capital Losses
It always makes sense to periodically review your investment portfolio to see if there are any "losers" you should sell. This is especially true with the present market volatility and threats of recession and as year-end approaches, since that is your last chance to shelter capital gains recognized during the year, as well as to take advantage of the $3,000 ($1,500 for married separate filers) limit on deductible net capital losses. However, one must be mindful not to run afoul of the wash-sale rule.
An often overlooked rule, the wash-sale rule provides that no deduction is allowed for a loss if you acquire substantially identical securities within a 61-day period beginning 30 days before the sale and ending 30 days after the sale. Instead, the disallowed loss is added to the cost basis of the new stock. However, there are ways to avoid this rule. For example, you could sell securities at a loss and use the proceeds to acquire similar, but not substantially identical, investments. If you wish to preserve an investment position and realize a tax loss, consider the following options:
- Sell the loss securities and then purchase the same securities no sooner than 31 days later. The risk inherent in this strategy is that any appreciation in the stock that occurs during the waiting period will not benefit you.
- Sell the loss securities and reinvest the proceeds in shares in a mutual fund that invests in securities similar to the one you sold or reinvest the proceeds in the stock of another company in the same industry. This approach considers an industry as a whole, rather than a particular stock. After 30 days, you may wish to repurchase the original holding. This method may reduce the risk of missing out on any anticipated appreciation during the waiting period.
- Buy more of the same security (double up), wait 31 days and then sell the original lot, thereby recognizing the loss. This strategy allows you to maintain your position but also increases your downside risk. Keep in mind that the wash sale rule typically will not apply to sales of debt securities (such as bonds) since such securities usually are not considered substantially identical due to different issue dates, rates of interest paid and other terms.
Invest in a Qualified Small Business Corporation
C corporations, including qualified small business corporations (QSBCs), received a huge tax cut under the TCJA—a flat 21 percent tax rate. (Under previous law, the top rate was 35 percent.) A QSBC is generally a domestic C corporation whose assets don't exceed $50 million. In addition, 80 percent or more of the corporation's assets must be used in the active conduct of a qualified business. There are other requirements as well. Contact us for further information.
The greatest advantage of owning QSBC stock is the ability to shelter 100 percent of the gain from a stock sale. Another significant benefit is the ability to defer the gain on a stock sale to the extent you acquire replacement QSBC stock within 60 days of the original sale. You must have held the stock for more than six months to take advantage of this break. When combined with the new 21 percent tax rate, these benefits can make operating a business as a QSBC more tax-efficient than operating it as a pass-through entity such as a sole proprietorship, partnership, LLC or S corporation.
Invest in a Qualified Opportunity Fund
Added by the TCJA, qualified opportunity funds (QOFs) are entities that invest in certain low-income communities (known as qualified opportunity zones). They provide unique planning opportunities for investors who have gains to defer. But opportunity zone investments are not for everyone. While the tax incentives are valuable, the investments are new and not without risk.
There are two major tax benefits of investing in qualified opportunity zones. The first is an election to temporarily defer and partially exclude gain from the sale of property if such gain is reinvested in a QOF. Gains may be deferred until the taxpayer sells their interest in the QOF, or December 31, 2026, whichever occurs first. Additionally, 10 percent of the gain may be excluded if you hold the QOF investment for at least five years, with an additional 5 percent exclusion, for a total of 15 percent, if the investment is held for at least seven years. The second is an election to permanently exclude from income post-acquisition capital gains on the disposition of QOF investments held for 10 years. QOFs are a hot topic right now, and quite complex, so please contact us if you're considering investing in QOFs.
Reevaluate Your Deduction Strategy
In most cases, it's advantageous to itemize your deductions if you have significant deductible expenses and these expenses, in the aggregate, exceed your standard deduction. If you cannot itemize, however, you can take advantage of the standard deduction. For 2019, joint filers can utilize a standard deduction of $24,400. The standard deduction for heads of household is $18,350, and single taxpayers (including married taxpayers filing separately) can claim a standard deduction of $12,200.
Unfortunately, the TCJA suspended or limited many of the itemized deductions. For example, the deduction for state and local taxes is limited to $10,000 ($5,000 if married filing separately).
The TCJA temporarily increased the limit on cash contributions to public charities and certain private foundations from 50 percent to 60 percent of adjusted gross income. However, with the increased standard deduction and limits on itemized deductions, it's likely fewer taxpayers will be eligible to deduct charitable contributions for 2019 without some advanced tax planning.
One way to remain charitable while enjoying related tax benefits is to bunch or increase charitable contributions in alternating years. This may be accomplished by donating to donor-advised funds. Also known as charitable gift funds or philanthropic funds, donor-advised funds allow donors to make a charitable contribution to a specific public charity or community foundation that uses the assets to establish a separate fund. Taxpayers can claim the charitable tax deduction in the year they fund the donor-advised fund and schedule grants over the next two years or other multiyear periods. This strategy provides a tax deduction when the donor may be subject to a higher marginal tax rate while actual payouts from the account can be deferred until later. The use of donor advised funds, however, requires accurate and precise planning. If you are considering the use of donor advised funds, contact us so that we may obtain a complete understanding of your entire tax situation.
Qualified Charitable Distributions
You can also lower your taxable income by directing RMDs from a retirement account other than a SEP or simple IRA to a charity. By converting your RMD into a qualified charitable distribution (QCD) you can exclude up to $100,000 of your RMD (per taxpayer) from taxable income by having the retirement distribution payable directly to a qualified charity, subject to certain rules. This allows you to remain charitable, lower your taxable income while simultaneously utilizing the higher standard deduction under the TCJA.
Establish a Qualified Tuition Plan and Take Advantage of Expanded Features
Although the particulars of qualified tuition plans (QTPs) can vary widely, they generally allow parents and grandparents to set up college savings accounts for children and grandchildren before they reach college age. Once established, QTPs qualify for favorable federal (and often state) tax benefits, which can ease the financial burden of paying for college. QTPs may be particularly attractive to higher-income parents and grandparents because there are no income-based limits on who can contribute to these plans.
Under pre-TCJA law, the earnings on funds in a QTP could be withdrawn tax-free only if used for qualified higher education at eligible schools. Eligible schools included colleges, universities, vocational schools or other postsecondary schools eligible to participate in a student aid program of the Department of Education.
TCJA permits qualified higher education expenses to include tuition at elementary or secondary private or religious schools up to a $10,000 limit per tax year. As a result, this is the perfect time to set up a QTP if you have children or grandchildren attending elementary or secondary schools.
Consider Adjusting Tax Withholding or Estimated Payments
Some taxpayers were surprised they owed taxes for the 2018 tax year, or were similarly surprised when they received a substantially lower refund than in previous years. In many cases, this was because they did not adjust their tax withholding or estimated payments as a result of tax reform. For those accustomed to receiving refunds every year, an unexpected tax bill cannot only be surprising, but can be a real hardship. Fortunately, there is still time to make sure the right amount of federal income tax is being withheld from your paychecks for 2019.
IRS Form W-4 instructs your employer how much tax to withhold from each paycheck. If you had a balance due with your 2018 tax return, you may want to decrease the number of allowances claimed on Form W-4. While the IRS recommends using its "Withholding Estimator" available at www.irs.gov, we recommend a more precise approach. A 2019 tax projection prepared by a qualified tax professional is the best and most accurate way to evaluate the status of your withholding and any required estimated tax payments, particularly if you have investment income and capital gains or are self-employed and earn income not subject to withholding.
Please keep in mind the IRS made changes to the 2018 threshold for the imposition of penalties for underwithholding by reducing required tax payments to 80 percent (as opposed to 90, 100 or 110 percent depending on your level of income) of your ultimate tax liability paid in via withholding or estimated payments. We believe it is unlikely the IRS will make those same concessions for the 2019 tax year. If you received underpayment penalty relief in 2018, you may not receive the same benefit in 2019.
High Medical Expenses? Pay Attention to Filing Status
For married couples, filing a joint return usually produces the best tax results. However, if one spouse has substantial unreimbursed medical expenses, he or she may pay less tax by choosing a "married filing separately" status (assuming deductions are itemized by both spouses on their respective returns). That's because for 2019, only medical expenses that exceed 10 percent of adjusted gross income are deductible. By filing separately, the spouse with high medical expenses generally lowers his or her adjusted gross income, which allows a larger deduction for medical expenses. Please note that if you live in one of the nine community property states (Louisiana, Arizona, California, Texas, Washington, Idaho, Nevada, New Mexico and Wisconsin) this strategy may not work for you as income and expenses must be split equally unless attributable to separate funds.
Planning for Small Businesses
If you own a business, consider the following strategies to minimize your 2019 tax bill.
Maximize Your Qualified Business Income Deduction
Thanks to the TCJA, business owners may deduct up to 20 percent of their qualified business income (the QBI deduction) from sole proprietorships and pass-through entities such as partnerships, LLCs and S corporations. The deduction is complex and subject to various rules and limitations based on your taxable income, the type of business you operate and your business' W-2 wages and property. Planning strategies should be considered now to maximize your deduction.
Planning for the QBI Deduction
Since your business' W-2 wages may impact your deduction, increasing W-2 wages may potentially allow for a more favorable deduction. It may be helpful to increase year-end bonuses or convert independent contractors to employees―assuming the benefit of the qualified business income deduction outweighs the increased payroll tax burden. Also, if your deduction is limited because your taxable income is too high, consider reducing your income by:
- contributing to an employer retirement plan
- making deductible IRA contributions
- contributing to a health savings account
- deferring business income or accelerating business expenses, or
- using donor-advised funds (see above) to effectively deduct charitable donations for several years within a single tax year.
Qualified Business Deduction for Real Estate Activities
If you own rental real estate, your activities may qualify for the QBI deduction. Under guidance issued by the IRS, rental real estate is eligible for the deduction if you keep separate books and records for the activity; perform 250 or more hours of rental services per year; and maintain reports, logs or similar documents that show the hours of all services performed, a description of all services performed, the dates on which the services were performed and who performed the services. If you don't meet these requirements, it's still possible that your rental activities qualify for the deduction. Further analysis and planning is advised to ensure the activities rise to the level of a trade or business.
Acquiring business assets may be a good tax planning move. Your business may be able to take advantage of generous Section 179 deduction rules. Under these rules, businesses can elect to write off the entire cost of qualifying property rather than recovering it through depreciation. The maximum amount that can be expensed for 2019 is $1.02 million. This amount is reduced (but not below zero) by the amount by which the cost of qualifying property exceeds $2.55 million.
Above and beyond the Section 179 deduction, your business also can claim first-year bonus depreciation. The TCJA established a 100 percent first-year deduction for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for certain property with longer production periods). Unlike under prior law, this provision applies to new and used property.
Involve Your Children in the Family Business
If you're self-employed, consider hiring your child as an employee. This would shift income (which isn't subject to the kiddie tax) from you to your child, who is likely in a lower tax bracket or may avoid tax entirely due to the standard deduction. There also may be payroll tax savings since wages paid by sole proprietors to their children age 17 and younger are exempt from Social Security, Medicare and federal unemployment taxes. For more information on summer employment of students, read our recent Alert.
Jumpstart Retirement Savings for your Children
Employing your children has the added benefit of providing them with earned income, which enables them to contribute to an IRA. Children with IRAs, particularly Roth IRAs, have a great start on retirement savings since the compounded growth of the funds can be significant. Remember a couple of things when employing your child. First, the wages paid must be reasonable given the child's age and work skills. Second, if the child is in college or entering soon, too much earned income can have a detrimental impact on the student's need-based financial aid eligibility.
As the IRS continues to release guidance on the new law, it is prudent to focus on planning opportunities to minimize your tax obligations. By investing a little time now, you may discover significant tax-saving opportunities. Additionally, another election year is on the horizon. With possible changes at various levels of government, the TCJA could be expanded, contracted or eliminated. Of course, with tax legislation, nothing is certain. As major legislative developments and opportunities emerge, we are always available to discuss the impact of a new or pending tax law on your personal or business situation.
For Further Information
If you would like more information about this topic or your own unique situation, please contact Michael A. Gillen, Steven M. Packer, or any of the practitioners in the Tax Accounting Group. For information about other pertinent tax topics, please visit our publications page.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.