How to Realize Tax Savings When Tax Rates Increase

Are You Eligible for the Research & Development Tax Credit?

On September 13, 2021, the House Ways and Means Committee released draft legislation that would increase federal tax rates for corporations and high-income individuals, generally effective for taxable years beginning after December 31, 2021.

Here is an overview of the proposed revisions:

  • The corporate tax rate would increase from a flat 21 percent rate to a tiered rate as follows:
    • Income up to $400,000: 18 percent
    • Income over $400,000 and up to $5 million: 21 percent
    • Income over $5 million: 26.5 percent
  • The top marginal ordinary income tax rate for individuals would increase from 37 percent to 39.6 percent;
  • A 3 percent surcharge tax would be imposed on incomes of estates/trusts over $100,000 and individuals over $5 million;
  • The 3.8 percent net investment income tax would be expanded to include S Corporation earnings for active owners in the case of high-income individuals; and
  • The maximum capital gain and qualified dividend rate would increase from 20 percent to 25 percent (28.8 percent including the net investment income tax).
     
    Note that the increased tax rate on long-term capital gains and qualified dividends is currently proposed to apply retroactively to income recognized after September 13, 2021.

If the current proposals are enacted, the timing of income recognition and deductions becomes critical for taxpayers that want to minimize their tax liabilities for 2021 and subsequent years. The general strategy when tax rates go up is to accelerate income recognition so that income is taxed at the existing lower rate, and to defer deductions so that they generate future tax benefits at the higher rate. With proper planning, this strategy can result in permanent tax and cash savings over time.

Tax Savings Opportunities When Tax Rates Increase

If implemented properly, the tax savings opportunities discussed below could lower a corporation’s overall tax bill if rates increase, including lowering overall costs for individuals who receive flow-through income from businesses held in LLCs, partnerships, or S Corporations.

Income Acceleration

Some of the common ways to accelerate taxable income include:

  • Advance payments. Taxpayers are generally required to recognize advance payments as income using either the one-year deferral method or the full-inclusion method. Adopting or changing to the full-inclusion method may allow taxpayers to recognize the income earlier; i.e., when the payments are received.
  • Installment sale. If any proceeds associated with a sale are to be received after the close of the taxable year, taxpayers generally are required to use the installment sale method to defer the portion of the gain associated with the unpaid proceeds. However, taxpayers may elect out of the installment sale method, which would cause the total gain to be recognized in the year of the sale.
  • Sale lease-back. Taxpayers that sell appreciated property and then lease it back generally recognize the gain in the year of the sale and generate future year deductions for the lease expense. However, sale lease-back transactions structured or recharacterized as financing transactions would not have the same tax result.

Deduction Deferral

For certain liabilities that are generally deductible based on when they are paid, if contractually feasible, accrual method taxpayers may be able to defer the payment of the liability so that the deduction falls in the higher rate tax year.

Examples of these liabilities include:

  • Accrued liabilities. Subject to limitations, certain accrued liabilities such as warranties, rebates, insurance, and taxes are generally deductible when they are paid.
  • Accrued compensation. Certain compensation such as bonuses or severance is generally deductible when accrued provided the payment is made within two and a half months after the end of the taxable year. If the payment is further delayed, the deduction is allowed in the tax year in which the payment is made.
  • Related party payments. Certain related party liabilities such as interest and service fees—including liabilities owed to cash method related parties or foreign related parties—typically may not be deducted until the payment is made or recognized as income by the related party.

Other common ways to increase future tax deductions include:

  • Expense capitalization. Qualifying expenses such as research and experimental (R&E) costs and certain costs associated with tangible or intangible property may be either deducted in full in the current year or capitalized and amortized over an extended period. If the expense is capitalized, the period over which it is fully deductible may be lengthy.
     
    Note that under current law, R&E expenses are required to be capitalized beginning for tax years beginning after 2021. However, modifications to extend the immediate expensing ability are under consideration and will need to be considered if tax legislation is enacted.
  • Depreciation. Taxpayers may elect to forgo bonus depreciation or immediate expensing (Section 179) for fixed assets. By electing out, taxpayers will depreciate the fixed assets over their respective tax lives instead of fully deducting the cost of the fixed asset in the year of acquisition.
     
    Note that certain opportunities listed above for income acceleration or deduction deferral require the taxpayer to change their method of tax accounting for the particular item of income or expense under specific automatic or non-automatic procedures.

Other Considerations

​Whether a particular strategy can provide tax savings depends on the taxpayer’s tax posture, future tax rates, future company performance, and other specific facts and goals of the business and its owners. Regardless of whether tax rates increase in 2022, taxpayers should begin reviewing their tax profiles and model the tax benefits associated with any feasible tax savings opportunities, especially for those requiring action before the end of 2021.

Katrina R. Samarin can be reached at Email or 215.441.4600.

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