As the 2020 presidential election approaches, many are looking ahead to how tax rates will be shaped by the next administration. President Trump and former Vice President Joe Biden hold strikingly different views on tax law, with planned changes to the current law expressed by both candidates.
A Biden win could lead to major changes to the 2017 tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA). While President Trump has expressed interest in making expiring provisions in the TCJA permanent, Biden would look to phase out certain TCJA provisions, and reset pre-TCJA tax rates for individuals with higher income. President Trump has also expressed plans to further reduce capital gains tax rates from 20% to 15% for individuals with higher income, while Biden plans to increase capital gains tax rates to 39.6% for taxpayers with income over $1 million.
Beyond the White House, majority support in the House and the Senate will also impact prospects for new legislation in 2021. President Trump will need to secure a net gain of 15 Republican seats in the House, while Democrats will need to see a net gain of five seats to gain the Senate majority. Regardless of the outcome of the 2020 election, it’s clear that the ideological differences between the two political parties around tax rates means at least some change is coming in 2021 via tax legislation. It’s the right time to begin thinking about tax moves that respond to these changes.
Accounting Method Strategies
Typically, taxpayers seek to defer recognition of income and accelerate the recognition of deductions. While this logic is sound under normal circumstances, the prospect of higher tax rates means the opposite approach may prove more beneficial. There are several accounting method strategies that can help to achieve this, as long as the taxpayer’s business goals and anticipated future earnings align with the strategy.
One such tax strategy to consider is switching from a deferral to a full inclusion reporting method for advance payments. While taxpayers use the deferral method to defer taxes on advance payments or unearned income to the subsequent tax year, taxpayers desiring to accelerate income may choose to recognize all of the advance payment in taxable income during the year of receipt. This strategy is particularly useful for taxpayers anticipating a near-term sale of the business where tax rates may be on the rise. Alternatively, a taxpayer may consider a change in overall method of accounting from the cash to the accrual method, which achieves conceptually similar effects to switching from a deferral to a full inclusion method.
Similarly, taxpayers with LIFO inventories that are anticipating a sale may want to revoke the LIFO election ahead of time, to begin computing inventory under the FIFO valuation approach. The taxpayer recognizes the difference to taxable income caused by the switch from LIFO to FIFO under Section 481, where 25% of the catch-up is recognized in the year of change, and the remaining 75% is recognized over the next three years. Accelerating income in tax years with lower rates can be beneficial, particularly in circumstances where taxpayer plans to trigger short-term changes anyway.
If Biden wins the 2020 election and Democrats take control of the Senate, planning for long-term capital gain rate increases is prudent. Biden has proposed resetting the maximum ordinary tax rate for individuals to the pre-TCJA 39.6% rate, and also applying that maximum tax rate to long-term capital gains. This could increase the long-term capital gains rate from 20% to 39.6% for individuals with higher income. If the net investment income tax remains unchanged, that boosts the effective rate on capital gains to 43.4%. To offset these changes, it may be beneficial to accelerate planned capital gains into 2020 to take advantage of the lower rates. Even if this change results in short-term capital gains (which are presently taxed at a maximum 37% tax rate), substantial long-term value can still be realized.
For businesses contemplating installment sales, electing to opt out of this method for 2020 tax returns may result in savings as well. Under the typical installment method, businesses that sell assets elect to recognize gains on an installment basis, where gain is recognized ratably as payments are received from the buyer. By electing out of this method, the long-term savings are more substantial than the short-term cost of opting out (if future tax rates are higher).
An added flexibility for this strategy is that any decision to elect out of installment reporting can be deferred until the time the 2020 tax return is filed. This means that businesses can sell before the end of year, and decide on the recognition method at a time when there is more certainty about future tax rates.
In a like-kind exchange, the unrealized gain on the exchanged property is not taxed immediately if the property is exchanged for like-kind property. However, under the proposed Biden plan, like-kind exchanges could be phased out for individuals with income over $400,000. There are two strategies to consider concerning like-kind exchanges.
For taxpayers that have an in-process like-kind exchange and that have plans to dispose of the replacement property within a few years, it may make sense to “break” the in-process like-kind exchange. This could be accomplished by failing to identify replacement property by the required time. The result would cause taxation for the exchanged property in 2020, and less gain potential for the replacement property that the taxpayer plans to sell several years later.
For taxpayers with near-term plans to replace a property but hold the replacement property indefinitely, consider moving quickly to take advantage of the like-kind exchange rules while they last. If a like-kind exchange commences in 2020, it is reported in 2020 even if the exchange is completed in 2021. Therefore, a taxpayer should engage a qualified intermediary during 2020 to hold the proceeds for the exchanged property, and complete the like-kind exchange during the 45-day identification period and the 180-day exchange period.
Although the outcome of the 2020 election remains uncertain, near-term changes to tax legislation are likely. Now is the time to begin preparing a tax strategy to make the best of these changes. For more information about how the election may affect your organization, please contact us.
Bill Smith is a Managing Director for CBIZ MHM’s National Tax Office. He can be reached at 301.907.2412 and firstname.lastname@example.org.
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