Through the same budget reconciliation process that Republicans used in 2017 to enact the Tax Cuts and Jobs Act (TCJA),1 Democrats in Congress have proposed legislation that would, among other things, increase tax rates on corporations and high-income individuals beginning with the 2022 tax year.2 While at the time this article went to press it was unknown what shape any final legislation might take, the House proposal would replace the flat 21% corporate tax rate with a graduated rate structure with a top rate of 26.5%. The top marginal individual income tax rate would increase from 37% to 39.6% for individuals with taxable income exceeding certain thresholds. Some passthrough businesses would see their marginal rate increase from 29.6% all the way to 46.4%, taking into account a proposed phaseout of the Sec. 199A deduction, expansion of the 3.8% net investment income tax, and a 3% surcharge on high-income individuals.
With these or other potential rate increases in mind, and depending on the contents of any final legislation, taxpayers may be looking for strategies to accelerate income into 2021 or defer deductions into 2022. This article begins by discussing a few factors taxpayers should consider before adopting income acceleration strategies and then outlines seven strategies to accelerate income.
Does income acceleration make sense?
Yogi Berra is often credited with saying "it's hard to make predictions, especially about the future." As of this writing, there is no certainty that proposals to increase taxes will be enacted. Case in point: Some wealthy taxpayers gifted significant portions of their wealth in anticipation of a sunset of the enhanced lifetime gift exemption at the end of 2012. Congress extended the enhanced exemption, leaving some taxpayers wishing they had not made the gift. Some of the acceleration strategies discussed below can be implemented after year end, providing some level of benefit to taxpayers who choose to adopt a wait-and-see approach.
Even if tax changes are adopted, an acceleration strategy does not make sense in all circumstances. Some taxpayers will not face higher marginal tax rates in 2022. For example, C corporations generating up to $400,000 of taxable income would see their marginal U.S. federal income tax rates drop from 21% to 18% under the House proposal. As another example, graduated tax rates may cause an individual taxpayer to be subject to lower marginal tax rates in 2022 if their taxable income declines.
Taxpayers who expect tax rates to go up next year may still prefer to defer income to the extent possible, depending on their cost of capital. For example, a taxpayer with cash sitting in a checking account earning essentially no interest may happily pay $1 of tax today to save $1.10 of tax next year. A taxpayer raising pricey venture capital or racking up credit card bills may prefer to save the $1 of tax today even if it means paying more tax next year.
Strategies to accelerate income
Once a taxpayer decides he or she would like to accelerate income, the next step is to identify available strategies, estimate the amount of income the taxpayer could accelerate with each strategy, and select those strategies that work best for the taxpayer's circumstances. Here are seven proven acceleration strategies.
Strategy 1: Accelerate collections and defer payments
Under the overall cash method of accounting, items of gross income are generally included in taxable income in the tax year in which they are actually or constructively received.3 Expenses are generally deducted in the year they are actually paid.4 Taxpayers using the overall cash method may be able to accelerate income by increasing collections before year end (e.g., by invoicing early, making collection calls, offering early-payment discounts, etc.) and/or delaying payment of expenses until 2022.
Strategy 2: Defer equipment purchases
Taxpayers can generally expense the cost of new or used equipment and certain other fixed assets acquired and placed in service during the year.5 Delaying acquisition of equipment defers the deduction. Property is generally placed in service when it is ready and available for use, even if not actually used, so delaying initial use of the property is not sufficient to defer the deduction.
If equipment acquisition cannot be delayed, depreciation deductions can be deferred to later years by electing out of bonus depreciation. Depending on the recovery period of the property, however, the cost of deferring the deduction may outweigh the benefit of using the depreciation to offset income taxed at higher rates.
Strategy 3: Roth conversion
Traditional IRA contributions are generally tax-deductible and withdrawals are taxable. In contrast, Roth IRA contributions are not deductible and withdrawals are generally not taxable. Taxpayers looking to accelerate income may want to convert a traditional IRA to a Roth to take advantage of the 2021 rates and allow tax-free distributions from the account during retirement.
Strategy 4: Alter compensation plans
Many accrual-method taxpayers structure their compensation plans to satisfy the all-events test as of year end, allowing bonuses and other compensation paid within 2½ months after year end to be deductible in the year of accrual. For example, an employer may establish a bonus pool of a fixed dollar amount prior to year end, allowing the all-events test to be met with respect to accrued bonuses even if the amount of each employee's bonus has not yet been determined.6 There may be an opportunity to alter the compensation plan so that the all-events test is not satisfied as of year end (e.g., by not creating a fixed bonus pool or specifying that amounts payable to employees who leave prior to payment revert to the employer), delaying the deduction for accrued bonuses. Alternatively, payment of the accrued compensation could be delayed beyond 2½ months after year end. Sec. 409A should be considered before creating any plan that calls for the deferral of compensation.
Strategy 5: Change to full-inclusion method for deferred revenue
Accrual-basis taxpayers generally include advance payments in gross income in the year of receipt (the "full-inclusion method").7 However, taxpayers with applicable financial statements may apply a method of accounting to defer reporting the income until the later of the year (1) the revenue is reported in the financial statements and (2) following the year of receipt (the "deferral method").8 Taxpayers currently using the deferral method with respect to advance payments may be eligible to change their accounting method to the full-inclusion method using automatic change procedures, providing an opportunity to make this decision with hindsight. Note, however, that a positive Sec. 481(a) adjustment is generally taken into account over a four-year period, limiting the ability for this method change to accelerate income in some circumstances.
Strategy 6: Elect out of installment method
If all or part of the consideration in a sale transaction is received after the close of the tax year in which the sale occurred, the seller generally reports gain as proceeds are received under the installment method.9 However, the seller can elect to report the entire gain in the year of the sale.10 Depending on the facts (e.g., whether the installment sale occurred during 2021 pursuant to a binding written contract entered into on or before Sept. 13, 2021),11electing out of the installment method may allow the gain to be taxed at the old rates and may provide other benefits.12 The election out is made by reporting the gain on a timely filed return for the year of the sale, providing an opportunity to make this decision with hindsight.
Strategy 7: Capitalize expenses
Several elections are available to capitalize expenses that are otherwise deductible. Capitalizing expenses defers the deduction to a later year when tax rates may be higher. The decision can be made by the due date of the return, providing an opportunity to defer an expense with the benefit of hindsight. Depending on the recovery period for the capitalized cost, the cost of deferring deductions may outweigh any benefit from using the deduction in a year when tax rates are higher. For example, a capitalized repair to a commercial building would generally be recovered over a 39-year period. It may be preferable to use a deduction in 2021 to offset relatively lower-rate income than to use the deduction over 39 years. A few elections to capitalize expenses are highlighted below.
Costs of acquiring assets: Employee salaries, overhead costs, and certain other costs of acquiring assets are generally expensed, even if other acquisition costs are capitalized.13 Taxpayers can elect to treat these costs as part of the cost of acquiring the assets.
Prepaid expenses: Taxpayers can generally deduct prepaid payment liabilities — such as insurance, taxes, and warranty or maintenance service contracts — if the term covered by the prepayment does not exceed 12 months.14 Taxpayers can make an annual election to capitalize prepaids that would otherwise be deducted currently under the 12-month rule, even if they have adopted a method of accounting to expense these costs in the year of payment.15
Repair expenses: Under the tangible property regulations, certain repair costs can be deducted for tax purposes. If the repair costs are capitalized for financial statement purposes, the taxpayer can elect to capitalize repair costs that would otherwise be deducted for tax purposes.16
UNICAP and inventory methods of accounting: Inventory accounting and the uniform capitalization rules of Sec. 263A are complex. There may be opportunities to change methods of accounting (e.g., switching from LIFO to FIFO) that may defer deductions to later years. Some of these changes are automatic, some require Form 3115, Application for Change in Accounting Method, to be filed by year end.
Careful planning is needed
The proposed change in tax rates presents a one-time opportunity for some taxpayers to achieve permanent tax savings by accelerating income into lower-rate years. Of course, there is no one-size-fits-all approach to tax planning. Taxpayers will need to consider their unique situation to determine whether it is appropriate to attempt to accelerate income and, if so, which acceleration strategies are most appropriate.
3Regs. Secs. 1.446-1(c)(1)(i) and 1.451-1(a).
4Regs. Sec. 1.461-1(a)(1).
5Secs. 168(k)(1) and 179(a).
6See Rev. Rul. 2011-29.
7Sec. 451(c)(1)(A); Regs. Sec. 1.451-8(b).
8Sec. 451(c)(1)(B); Regs. Sec. 1.451-8(c). Taxpayers without an applicable financial statement can similarly defer recognition if they meet certain criteria (see Regs. Sec. 1.451-8(d)).
11Sept. 13, 2021, is the proposed effective date for capital gain tax rate changes under the "Build Back Better Act" legislation being debated in Congress as this article went to press.
12See Werlhof, "When Does It Make Sense to Elect Out of the Installment Method?" 52 The Tax Adviser 440 (July 2021).
13Regs. Secs. 1.263(a)-2(f)(2)(iv) and 1.263(a)-4(e)(4).
14Regs. Sec. 1.263(a)-4(f)(1).
15Regs. Sec. 1.263(a)-4(f)(7).
16Regs. Sec. 1.263(a)-3(n).
18Secs. 59(e) and 174(b). Taxpayers changing to the deferral method who have previously used the current expense method will need IRS permission to make the change.
|Nathan Richwine, CPA, J.D., is a manager in CliftonLarsonAllen LLP's Indianapolis office, and John Werlhof, CPA, is a principal in CliftonLarsonAllen LLP's National Tax Office in Roseville, Calif. For more information about this article, contact email@example.com.