Another Election Day is in the books, but as pandemic rages and the country deals with virtual schooling while anxiously waiting for the Georgia runoff election, we thought it would be helpful to highlight some of the tax law changes that may occur during the next administration, and some actions that taxpayers may wish to take before year-end. However, just as the solution differed depending on what school class was thinking about the issue, what a particular taxpayer should do is dependent on its specific facts, as there is no one-size-fits-all approach.

Effective Federal Income Tax Rates Are Probably Going to Increase

While in science class, one learns of gravity and Sir Isaac Newton’s “What goes up must come down,” however, when it comes to effective tax rates, it is more of an economics or accounting class concept. While the federal income tax rate reductions for individuals under TCJA are not set to expire until the end of 2025, many are anticipating that effective tax rates may increase sometime within the next few years.  There are several reasons for this view. First, over the past year, Congress has passed several COVID-19 relief bills that have generated exorbitant debt. Thus, during the next Congress, “deficit hawks” will be seeking ways to reduce the ballooning deficit. Additionally, if Republicans retain control of the Senate, it is highly anticipated that they will enforce the application of the PAYGO or “pay as you go” rule (which require that tax cuts and mandatory spending increases be offset by tax increases or cuts in mandatory spending) to most, if not all, of the bills originating in the Democratic House.  As a result, Democrats will be seeking mechanisms to pay for their policy goals so that they can account for items in a revenue-neutral way. Federal income tax rate increases will likely be on the table, as evidenced by some of President-elect Biden’s campaign proposals, including:

• Increasing the individual tax rate for taxable incomes above $400,000,
• Increasing Social Security payroll tax for wages above $400,000,
• Taxing individual long-term capital gains and qualified dividends at ordinary income tax rates for individuals whose income exceeds $1 million,
• Increasing the corporate income tax rate to 28%, and
• Establishing a 15% corporate minimum tax based on book income for corporations with consolidated global profits of at least $100 million.

As a result, Republicans will need to decide whether they want to block all the Democrats’ policies, which is most likely, or allow Democrats to increase taxes and use those increases as a talking point in the next election. With that said, even if the Republicans choose to block tax increases, there are still two reasons to believe effective tax rates are going to increase. First, some of the TCJA provisions will expire over the next several years (e.g., immediate deductibility of research and experimentation expenses; the add-back of depreciation, amortization, and depletion expenses in determining the amount of business interest expense that can be deducted; and 100% first year bonus depreciation). Second, even without new legislation, a Biden Treasury can issue regulations that scale back benefits provided in existing regulations (e.g., the Global Intangible Low Taxed Income (GILTI) high tax exception and treating capitalized depreciation, amortization and depletion as expenses for section 163(j) business interest expense limitation purposes, but not for base erosion and anti-abuse tax (BEAT) purposes).

So, Federal Income Tax Rates Are Going to Go Up … Now What?

When taxpayers hear that tax rates are going up again, they traditionally either do The Rocky Horror Picture Show’s Time Warp or think of their environmental classes and recycle the concepts of accelerating income and deferring deductions, so income is taxed at a lower tax rate and deductions are taken against income that will be taxed at a higher rate.  However, because of the changes made by TCJA and the CARES Act, whether that approach would be truly beneficial is dependent on the taxpayer’s particular facts, including the applicability of the following provisions:

• Net operating losses
  • Under the CARES Act, taxpayers are allowed to carry back net operating losses (NOLs) arising in taxable years beginning after December 31, 2017, and before January 2021 to the five preceding taxable years, including years in which the federal corporate income tax rate was 35%.
  • Under TCJA, as modified by the CARES Act, the NOL deduction in taxable years beginning after December 31, 2020 is limited to 80% of modified taxable income potentially deferring and reducing the present value of NOLs.
• Loss limitation for pass-through businesses and sole proprietors
  • Under the CARES Act, the limitation in section 461(l) on the ability of owners of pass-through businesses and sole proprietorships to use trade or business losses to offset non-business income was deferred until taxable years beginning after December 31, 2020. Other limitations that generally apply to trade or business losses (e.g., the at-risk limitations and the passive activity loss limitations) also still apply.
• Section 163(j) interest expense limitation
  • Under the CARES Act, a taxpayer can calculate its 2020 section 163(j) interest expense limitation based on its 2019 adjusted taxable income (generally EBITDA), instead of its 2020 adjusted taxable income. Therefore, deductions in 2020, will generally not affect the deductibility of a taxpayer’s interest expense.
  • For taxable years beginning on or after November 13, 2020, the final section 163(j) regulations, described here, are applicable. However, for prior taxable years, taxpayers can choose to apply either the proposed or the final regulations or may disregard the regulations and apply a reasonable method.
• Payroll tax deferral
  • Under the CARES Act, as modified by the Paycheck Protection Program Flexibility Act of 2020, employers can defer the employer portion of Social Security taxes that would otherwise be due from March 27, 2020 through December 31, 2020 (of which 50% will become due on each of December 31, 2021 and 2022). Therefore, for taxpayers who took advantage of this program, payroll costs will be lower than normal in the current year and higher than normal next year.

As illustrated by the following examples, the interplay of these various provisions under a taxpayer’s particular facts can be difficult.

Example 1: Without any tax planning, X would have a net operating loss (NOL) of $400 in 2020. However, X could accelerate $450 of income from 2021 to 2020, which would result in X having taxable income of $50 in 2020.  In determining whether this would be beneficial, X needs to take into account a host of considerations, including whether X could carry back its $400 NOL to a taxable year in which the tax rate was higher than the anticipated future rate (e.g., the 35% tax rate of 2015 versus the anticipated 2021 tax rate, which Biden proposed to increase to 28%), in which case X might not want to accelerate the income.  If such a carryback is not available, then it may be beneficial to accelerate the income so that X can use the NOL to offset all the income, as opposed to just 80% of taxable income in 2021. X would also need to consider the impact of accelerating the income on its ability to deduct business interest expense. For example, if X is using its 2019 adjusted taxable income as the basis for its section 163(j) interest deduction limitation in 2020, then the acceleration of income into 2020 will not affect its ability to deduct interest in 2020, but it will reduce X’s section 163(j) interest expense limitation in 2021. 

Example 2: X’s employees expect that individual tax rates will increase. To alleviate this burden, X is considering whether it should accelerate bonuses or other income into 2020.  In making this determination, X must first determine whether doing so would run afoul of statutory limitations, including sections 162(m) (limiting the deduction on certain “excessive” employee compensation) and 409A (prohibiting the acceleration of certain deferred compensation). If otherwise permissible, X may want to accelerate the bonuses because the resulting deduction may generate or increase an NOL that may be carried back, may not be factored into X’s 2020 section 163(j) interest deduction limitation and can qualify for deferral of the employer’s portion of Social Security taxes. On the other hand, X may not want to accelerate the deduction if doing so would not generate or increase X’s NOL carryback, because the deduction will offset income that would otherwise be taxed at the lower 2020 rate.

Deferred Compensation Plans Should be Reviewed

Taxpayers have until December 31, 2020 to review, and potentially modify, compensation arrangements that were in effect on November 2, 2017 (pre-TCJA arrangements).  Meeting this deadline is essential to ensure that pre-TCJA arrangements continue to be grandfathered from the TCJA changes. As part of TCJA, section 162(m), which limits deductions for compensation for a “covered employee” to $1 million a year, was expanded in both the scope of who is a “covered employee” and the duration of “covered employee” status (it now includes payments made after the individual’s death). However, pre-TCJA arrangements were grandfathered from TCJA’s changes to section 162(m) so long as they are not materially modified after November 2, 2017. The issue arises because Treasury and the IRS have allowed employers to delay paying deferred compensation that is otherwise nondeductible under section 162(m) until a taxable year when section 162(m) would not limit the deduction, without running afoul of section 409A, so long as such payment occurs as soon as section 162(m) does not apply. Regulations that were proposed in 2019 allow taxpayers to amend their pre-TCJA arrangements by December 31, 2020 to remove the language delaying payments that are nondeductible under section 162(m) without causing the modification to result in a section 409A violation or a loss of grandfathered status, so long as any payments that are required to be made prior to December 31, 2020 are made by such date.

A&M Insight: While it is possible that the final regulations may provide greater transition relief, we strongly encourage taxpayers to act now. It is also important to note that the determination of which compensation arrangements will require amendments and payment prior to December 31, 2020 is complex and if preformed incorrectly, could result in adverse tax consequences. 

Wait … There’s More?

Recognizing that we are in December, we would be remiss if we did not also highlight some of the more traditional year-end tax planning issues that taxpayers should consider.

It’s Documentation Time

As the year comes to a close, now is the time to make sure that you have the documentation on hand that is necessary to support your tax return positions. TCJA made several changes that will require documentation to support deductions in addition to what was previously required. The two that are most likely to arise are meals and entertainment expenses and the deduction for Foreign-Derived Intangible Income (FDII).  As discussed during our November Virtual Coffee Talk on the Final Meal and Entertainment Expenses Regulations, taxpayers are now required to maintain much more detailed documentation regarding meal and entertainment expenses to determine whether the amounts paid are deductible, and if so, whether they are deductible at 50 percent or 100 percent.  Additionally, as discussed in our article on FDII, taxpayers are required to maintain minimum substantiation to determine the benefits for which they are eligible.

A&M Insight: In addition to meal and entertainment expenses and income and expenses associated with FDII, taxpayers are urged to consider other required documentation. For example, over the past year, the IRS has raised numerous challenges to taxpayers’ transfer pricing benchmarks and documentation. In addition, a host of foreign tax authorities have also imposed new documentation requirements. There has also been great interest in documentation supporting energy tax credits. A&M is poised to assist taxpayers with evaluating their documentation to ensure that they have all they need to maximize their tax benefits.

“Use or Lose” Attributes

When most people hear “use it or lose it” they immediately think of accrued vacation that is forfeited at year-end if it is not taken.  Similarly, cancellation of indebtedness that is excluded from taxable income (excluded CODI) during a taxable year may cause certain attributes to be used or lost.  This is because when a taxpayer has excluded CODI, it must reduce certain attributes after calculating its tax liability for the year in which the excluded CODI arises.  If a taxpayer has tax attributes that could be reduced, it may be beneficial to find a way to fully utilize them before they are eliminated. Determining whether a taxpayer can use, or is better off using, the unreduced tax attributes requires some complex modeling.

A&M Insight: While the initial impulse to utilize vulnerable attributes is logical, certain circumstances may dictate that it is more favorable to the taxpayer not to do so, which can only be determined with proper modeling.  Additionally, taxpayers with excluded CODI may have options as to the ordering of the attributes that are reduced.  The A&M Restructuring Tax Services group address these issues on a daily basis and regularly helps its clients make informed decisions in this regard.

A Bigger Push for Onshoring

While there is very little that Democrats (including the President-elect) and Republicans agree on, onshoring is an area in which there is common ground. Both parties have expressed support for using the tax system to encourage the onshoring of manufacturing and jobs. In fact, during Biden’s campaign, he proposed:

• A penalty tax on profits of a US company derived from producing overseas for sale back to the US, and on call centers or other services provided overseas, but servicing the US; 
• A tax credit for certain costs associated with relocating the manufacturing of goods and call centers or other services back to the US; and
• An increase in the tax rate that is applicable to GILTI, which would in turn encourage taxpayers to onshore activities and qualify for lower tax rates on their FDII.

A&M Insight: It would not be surprising if any new tax reform included incentives for onshoring. That is not to say that companies should immediately onshore their activities, as it cannot yet be known what onshoring provisions may be included in future tax legislation. However, driven by factors including trade wars, changing costs, supply chain vulnerability, and an evolving tax and regulatory environment, many companies are evaluating changes to their operating model and supply chain, as well as determining whether aligning legal entity rationalization and simplification with those changes would be beneficial. A&M Taxand and Performance Improvement practices have the specialized skills and experience to help clients assess and realize the operational and financial benefits of these changes.

A&M Taxand Says

While Heraclitus encouraged us to expect the unexpected, over the coming years, while the administration and tax laws will be changing, two things will remain constant.  First, the tax law will continue to become more complex. Taxpayers will need to be nimble and to evaluate multiple models in light of the changing tax environment to determine their tax posture and how taxes should be factored into their business decisions. Second, A&M Taxand is a trusted resource that has the expertise to assist clients with these complex decisions. As highlighted in this alert, there truly is no one-size-fits-all approach, and taxpayers need a trusted adviser with expertise covering the latest guidance to help evaluate and accomplish their goals.  With the new year quickly approaching, time is of the essence.