Impact of Potential Tax Changes in 2021
The coronavirus pandemic resulted in changes to business taxes in 2021. Businesses saw many new tax incentives, breaks and rules as the U.S. government tried to combat COVID-19’s toll on the economy. Here are some of the new programs and changes:
- Coronavirus Aid, Relief, and Economic Security (CARES) Act. The CARES Act introduced the Paycheck Protection Program (PPP) as an emergency loan that allocated billions of dollars to small businesses. The PPP is a forgivable loan, so long as the funds are utilized to fund payroll, rent/mortgage and utility payments. Any money a business received and was forgiven through the PPP is not considered taxable income, though any amount that is not forgiven is taxable business income.
- Economic Injury Disaster Advances and Loans (EIDL). To help businesses affected by mandatory shutdowns or economic slowdowns caused by the coronavirus pandemic, the U.S. Small Business Administration (SBA) expanded the EIDL program. A business that received advances from an EIDL is not required to include these amounts in taxable income. EIDL loans are handled like any other loan for tax purposes.
- Employee Retention Tax Credit (ERTC). Businesses affected by COVID-19 can use the ERTC to retain staff members. To qualify, a business has to have been fully or partially closed due to a government-mandated shutdown or experience a decline in gross receipts of more than 50% for any given quarter when compared with the same quarter in 2019. Employers that qualify for the ERTC are eligible for a tax credit equal to 50% of qualifying wages, up to $10,000 per employee between March 13, 2020, and Jan. 1, 2021.
- Families First Coronavirus Response Act (FFCRA). The FFCRA required certain businesses to provide sick/family leave to employees who were affected by COVID-19. Businesses that made these payments are eligible for tax credits for 100% of the cost of sick-leave pay, family-leave pay, qualified healthcare plan expenses and the employer’s share of FICA taxes for sick-leave expenses they incurred under the FFCRA.
- Business interest expense deduction increases. Finally, under the CARES Act, the allowable business interest expense deduction was increased for some business entities from 30% to 50% of adjusted taxable income.
Key takeaway: The CARES Act, EIDL, ERTC and FFCRA played key roles in helping businesses weather the coronavirus storm in 2020. It is important to know how these changes may affect your taxes in 2021.
How future tax changes may impact small businesses
Small businesses are a driving economic force in the United States, with nearly 32 million firms (including sole proprietors) employing almost half of the nation’s private workforce (Small Business Administration).
Higher tax rates may impact certain pass-through businesses
Most small businesses are S corps, LLCs, partnerships, or sole proprietorships, and are structured as pass-through entities. Net income generated from these businesses flows-through to the owner’s individual tax return. Under the current House proposal, higher-income business owners would face a top marginal tax rate of 39.6% instead of the current 37% tax rate. Under the proposal, the top rate would apply to those with more than $400,000 in taxable income ($450,000 for married couples filing a joint return). The higher rate would apply to taxable years beginning after December 31, 2021.
The 3.8% surtax to include “active” business income
For nearly a decade, higher-income taxpayers have been subject to a 3.8% surtax on net investment income including, for example, interest from investments, capital gains, dividend income, rental income, royalties, and income from a business activity where the taxpayer is not considered an “active” participant. Under the current rules, income received by an individual who is actively participating in the business as defined by the tax code is not subject to the 3.8% surtax. The new proposal would modify this to impose the surtax on net investment income derived in the ordinary course of a trade or business.* This provision would apply to those with modified adjusted gross income exceeding $400,000 ($500,000 for couples) and is effective for taxable years beginning after December 31, 2021.
* The proposal would ensure that all pass-through business income of high-income taxpayers is subject to either the net investment income tax (NIIT) or self-employment tax.
Limits on the deduction for qualified business income (QBI)
The Tax Cuts and Jobs Act (TCJA) introduced a provision in the tax code which provides a 20% deduction for certain taxpayers receiving income from pass-through businesses depending on the nature of the business and their income. The current House proposal would set additional limits on claiming that deduction by limiting the amount of the total deduction to $400,000 for an individual tax return and $500,000 for a joint return. Note there are some other proposals being discussed in Congress, including the Small Business Tax Fairness Act, that would disallow the QBI deduction for taxpayers with income exceeding $400,000.
Restrictions on certain wealth transfer strategies
Since the House proposal calls for reducing the lifetime gift and estate tax exclusion from almost $12 million per person to roughly $6 million beginning in 2022, those holding a significant portion of their net worth in closely held business interests may need to review their current estate plans. There are a number of advanced strategies available to taxpayers to transfer closely held business interests tax-efficiently with respect to estate and gifts taxes, and potentially to income taxes. For instance, applying valuation discounts when transferring shares of a closely held business to the next generation. The IRS allows a “lack of control” discount when minority interest shares of a business are transferred. The lower the business ownership shares are valued, the greater the number of shares can be transferred under the existing gift tax rules. Another strategy involves selling appreciated shares of a closely held business to an intentionally defective grantor trust in exchange for a long-term promissory note. There may be no capital gains realized on the sale of the assets to the trust, and transfer of assets to the trust removes them from the grantor’s taxable estate.
The House proposal targets both of these strategies. First, valuation discounts would no longer apply to non-business assets, defined as passive assets that are held for the production of income and not used in the active conduct of a trade or business. Passive assets may include investment securities held by the business, for example. Valuation discounts would still be available for assets that are utilized during the normal course of operating the business. Lastly, the proposal would also, for example, consider the sale of assets to a grantor trust a taxable event if the grantor is deemed an owner of the assets. The effective date for both of these proposals is after the date of enactment, which means when the bill is signed into law.
House plans underscore the need for tax planning
Odds seem increasingly likely that Congress will succeed, using the budget reconciliation process, in passing a tax bill between October 1 and the end of the year.
The House proposals, and the larger debate to follow on budget reconciliation, could result in higher taxes for businesses. There are many ways that smaller businesses could face higher tax liabilities if these measures are approved. As with all policy developments, it’s important to monitor potential changes and discuss the impact on financial plans and tax-smart planning with a professional advisor or tax expert.
Tax changes alone shouldn’t dictate your decision to sell. That said, specific proposals under President Biden’s American Families Plan are impacting exit planning. Most salient include the proposal to nearly double the top long-term capital gains tax rate to 39.6% (43.4% if you include the net investment income tax), and taxing the appreciated value of unsold assets at the owner’s death. Long-embraced strategies for tax planning efficiencies are being upended by these proposals.
Consider, for example, a business owner planning to make a bequest of family business interests to his or her children at death. The owner could see that bequest treated as if it were a sale for income tax purposes, taxable at the 43.4% capital gains rate (subject to certain exemptions and payment deferrals); in effect, the owner could see a loss of the basis step-up tax benefit for gifts from holding those assets until death. Moreover, this tax would be independent of the gift and estate tax, currently assessed at 40% on amounts gifted or transferred at death in excess of $11.7 million per person. An increased estate tax rate and a lower exemption amount under the Biden plan would exacerbate the tax hit.
Key takeaway: Often you as an owner don’t have the luxury of scripting the precise timing and path between formation and exit. If external forces (e.g., market conditions or tax law changes) are driving the sale of your business before year-end, there’s still time for effective estate planning measures.Acting now could have a meaningful impact.