In this world there are few times where you can have your cake and eat it too. Is there a way you could give your employees a bonus that you get to deduct and they don’t have to claim as income? The answer to that is almost always “no” but this year, there might be a way.
COVID-19 and the president’s earlier declaration of a federal disaster for the states and territories of the United States of America invoked Section 139 of the Internal Revenue Code and the ability of an employer to make qualified disaster relief payments. Under the code, an employer can make relief payments to their employees that are both deductible to the employer and non-taxable to the employee. Most commonly, we see these declarations and payments made during the time of natural disasters, but the pandemic by way of the President’s declaration also qualifies.
Granted, an employer just can’t write a bonus check and call it a relief payment. The employer must do some due diligence about what qualifies as a qualified employer provided relief payment in order to provide tax-free funds to impacted employees. These relief payments do not have to be the same for each employee (but may be) nor do they have to be given to every employee. In other words, the employer has the discretion to help an employee that has been impacted more by the disaster than another by giving more to that employee.
A qualified disaster relief payment is for the following purposes:
A key here is that the payments made are reasonable in nature and for necessary expenses. They also cannot be for something that has already been accounted for by insurance or other means. (For example, if your health insurance plan covered testing of your employees, you couldn’t include the cost of the testing in your relief payment.)
The payments do not have to have significant documentation. In addition, proof of these expenses does not have to be provided by the employee.
Personally, I have seen money spent on protective gear, cleaning supplies and sanitizers as a result of the pandemic that I would not have normally spent. I have seen my home utilities increase as work and school from home happened. I have seen family members need to be tested and quarantine while awaiting results from possible exposure or symptoms and miss work. I have seen counseling visits and other therapy to help with the stress and anxiety that have come from the pandemic. All of these costs would not have been incurred absent the pandemic.
It is my belief that as long as the amounts are reasonable and for necessary expenses related to the pandemic and the purpose of the payment is documented, an employer can make pandemic related qualified relief payments to their employees for these and perhaps other expenses.
While not technically a bonus, providing a qualified relief payment to employees at this time of year provides a great tax deduction to the employer and tax-free money to impacted employees.
The Year in Review
It has been a busy year for Federal Income Taxation. In response to the pandemic, President Trump declared a nationwide emergency which allows states and territories to receive federal aid without needing to make individual requests. It also means certain losses under the disaster can be deducted in the prior year and certain assistance received is not taxable.
Congress passed the Families First Coronavirus Response Act (FFCRA) and created certain credits for certain employers (50-500 employees, less than 50 employees – participation is not mandatory) including emergency paid sick leave and emergency family and medical leave.
Congress then passed the Coronavirus Aid, Relief and Economic Security Act (CARES) which included aid to individuals and provisions to assist businesses. A key component of this act was the Payroll Protection Program Loan. This was a low interest rate loan that had the potential of forgiveness if spent on certain expenses including payroll. Congress had intended these loans to be non-taxable but failed to incorporate the proper language in the bill and the IRS is currently deeming any expenses paid for with a forgiven loan amount as non-deductible, essentially making the forgiven loan taxable. We hope that Congress corrects the language before adjourning for the year.
The CARES Act also provided individual stimulus payments of up to $1,200 per person, ($2,400 for a married couple and $500 for each qualifying dependent subject to income limitations). The amount paid is actually an advance payment of a 2020 tax return credit. As it was based on 2018 or 2019 income, there will be a true-up on your 2020 tax return. If you are entitled to a higher amount than received, you may get it as part of a refund or credit on your 2020 return. If you were overpaid based on your 2020 income, you will not owe the government.
Under the CARES Act, required minimum distributions from retirement plans were waived in 2020 allowing an individual to leave funds in the plan and keep 2020 income lower. The Act also allowed for certain loans from plans, temporary removal of early distribution penalties, and income staggering for Coronavirus-related distributions.
Net Business Loss limitations were also suspended for 2018, 2019 and 2020. This would allow claims for refunds where the business loss may have been limited. The limitation returns in 2021.
The CARES Act also created a $300 above the line charitable deduction for individuals who do not itemize. It also removed the 60% AGI limitation for 2020 and individuals can deduct up to 100% of their income (AGI) from made charitable contributions in 2020.
Several payroll related credits were also created for businesses including the Employee Retention Credit (for those who did not receive PPP loans) and Deferral of Employer Component of Payroll Taxes. Other business tax related items included in the Act are Corporate AMT Credit Refund, NOL Carryback extension, Bonus Depreciation, Business Interest Expense limitation adjustments and a temporary increase to the corporate charitable deduction.
2020 Tax Planning
As long term capital gains are taxed favorably compared to short term capital gains, you should consider holding capital assets for at least 12 months and a day to take advantage of the favorable rates (0%, 15% or 20% depending on income level). You may also consider gifting appreciated stock to charity or relatives in lower tax brackets who may pay less or no tax when the shares are sold. You may also want to harvest unrealized losses in your portfolio to offset current year gains.
Net Investment Income Tax (NIIT)
A 3.8% tax is assessed on net investment income (interest, dividends, capital gains, rental income and passive activities) if income is more than $200,000 for individuals or $250,000 for married couples. The impact of this tax can be lessened by using installment sales to spread income over many years thus potentially keeping your income below the threshold. You may also harvest unrealized loss positions in your portfolio to lower harvested gains. You may also consider investing in tax-exempt income as it is not subject to the NIIT.
Small Business Owners
As a business owner you have additional tools to assist in minimizing your tax bill.
If you file using the cash basis method on your taxes, you may consider deferring billing and collections until year-end thus pushing the receipt into 2021. If you file under the accrual method, you can delay shipping products or delivering service.
You may also accelerate your expenses by paying for business expenses by year-end. Remember that credit card charges are deductible in the year made rather than paid.
You may consider hiring your child. Having your child work in the family business allows them to pay tax on their wages at their tax rate and if they are under age 17, their wages are exempt from social security, Medicare and federal unemployment taxes. They should be paid through payroll, given a W-2 and be paid reasonably for the age and skills of the child. They can make up to $12,000 a year before they will pay income tax and $18,000 a year if they make an IRA contribution (maximum is $6,000).
If you have a home office that is used primarily for business activities, you may be able to take the home office deduction as a self-employed individual. Owners of S-Corporations, Partners or Multi-Member LLCs can be reimbursed for necessary home office deductions under an accountable plan and the business may take the deduction. You may also choose to reimburse these costs of your employees if they were working from home during the pandemic.
You may also consider acquiring assets you need for the business. It never makes sense to buy an asset solely to get a tax deduction but if you need it for your business, it is better bought in December than January. With Section 179 and bonus depreciation rules, you may be able to deduct the entire purchase in the current tax year.
If you itemize your deductions, you can deduct qualified medical expenses that exceed 7.5% of your adjusted gross income. Medical expenses that qualify are health insurance premiums (not deducted elsewhere), long term care insurance premiums, medical and dental services, prescription drugs, mental health services and prescribed medical equipment. As such, you may consider bunching elective medical procedures into 2020 if it will help you exceed the 7.5% limitation. The threshold will likely be increased to 10% in 2021.
With the additional $300 charitable deduction for those who do not itemize and increased limitations for those do, 2020 is a great year to donate to charity. Consider making your annual giving for next year in this year. Donate appreciated stock and avoid paying the capital gains tax and get a fair market value deduction for stocks held more than one year. You can also do the inverse and sell depreciated stock, harvest the loss and donated the cash proceeds to charity. This allows you to keep the loss and help the charity. (Remember the $3,000 per year capital loss deduction limitation.)
You may also max out your retirement contributions to lower your tax bill, whether it is your 401k or IRA. Remember contributions to ROTH accounts are not deductible but still a good savings vehicle.
Spending and Savings Account Contributions
If you have a Flexible Spending Account (FSA), you may contribute up to $2,750 and have it excluded from income. While generally these funds are “use it or lose it”, your employer may allow you to carryover $500.
If you qualify to make contributions to a Health Savings Account (HSA), you may contribute up to $3,550 as a single individual or $7,100 for family coverage. If you are 55 or older you may make an additional $1,000 contribution ($2,000 for a married couple both 55 or over).
Qualified Charitable Distributions (QCD)
If you have reached 70 ½, you can donate up to $100,000 per year from a IRA account directly to a qualified charity. The donation meets the minimum distribution requirement but is also excluded from your income. (Keep in mind that you cannot take a charitable deduction for this distribution. For 2020, you do not have a minimum distribution requirement.)
You can make up to $15,000 of tax-free gifts to individuals. Gifts over that amount in a calendar year are subject to gift tax. Married couples can elect to split gifts and therefore give up to $30,000 to an individual in 2020.
With the economic troubles caused by the pandemic, many individuals lost their jobs and were able to receive unemployment benefits including additional federal funds. While a lifesaver while unemployed, you should be aware that unemployment benefits are taxable and should be reported on your income tax return. You should plan for the tax hit if you have not already.
States have also made tax changes as a result of the pandemic including income sourcing, nexus and residency rules.
We are bound to see new tax changes as Congress looks to add stimulus and we start a new administration with a new tax policy. As Benjamin Franklin said, “In this world, nothing can be said to be certain except death and taxes.”
From what we can tell, when lawmakers originally passed the Paycheck Protection Program (PPP), they thought that under its provisions, two things would be true; you did not pay taxes on the forgiveness amount, and you also could deduct the expenses that you paid with the PPP money.
In late April, the IRS issued Notice 2020-32, which asserts that PPP loan recipients may not deduct business expenses paid using the PPP monies that gave rise to forgiveness (defined payroll, rent, utilities, and interest). This was contrary to the intent Congress thought they had provided.
In response the the IRS Notice, in a May 5, 2020, letter to Secretary of the Treasury Steven Mnuchin, Senator Chuck Grassley (chairman of the Committee on Finance), Senator Ron Wyden (ranking member on the Committee on Finance), and Congressman Richard E. Neal (chairman of the Committee on Ways and Means) jointly stated that the IRS got this wrong and that the intent of the CARES Act was for the PPP to be a tax-free grant.
The letter seems to make sense. You can read it here.
The IRS was unmoved by the lawmakers’ letter. The IRS position was clear: no deduction for the expenses paid with the PPP money. The IRS understood that perhaps lawmakers didn’t mean that to happen, but in the eyes of the IRS, the way that the lawmakers enacted the law created the problem. To fix it, lawmakers simply need to pass a new law.
We thought that lawmakers would pass a new law and take care of this problem. But that has not yet happened.
To once again firm up their position, on November 18, 2020, the IRS drove two new nails into the coffin regarding deductions for PPP monies that were forgiven and spent on payroll, rent, interest, or utilities.
With the rulings described above, the IRS has clarified its position and clearly stated to lawmakers: if you don’t like the non-deductibility of expenses paid with PPP monies, change the law.
We accountants thought we might be able to delay the non-deductibility by taking the expenses in 2020 and then recapturing the non-deductible expenses in 2021 when PPP Loan forgiveness was granted (paying taxes later is better than paying taxes now) but the IRS in these notices state that the expenses paid with PPP Loan funds are not deductible IF they are expected to be forgiven, regardless of when they are forgiven.
We are stuck unless Congress acts and soon.
So what can we do? Join with hundreds of thousands of business taxpayers and tax professionals who are urging lawmakers to fix the non-deductibility issue.
To help encourage the action you desire (whether you’re for or against deductibility), get in touch with your state’s lawmakers.
You don’t need to be big and formal about your yea or nay. You can fax, email, or phone and simply say you support or oppose the bill. It’s that easy—and it’s effective. Do it.
If you would like to discuss the effect non-deductibility has on your taxes, please call or email me.
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