How could the extraordinary effects of the COVID-19 pandemic and the possibility of tax law changes next year affect your year-end tax planning? Here are a few ideas.
2020 has thrown unprecedented challenges at auto dealers — and with most major news outlets projecting Joe Biden to win the presidency, significant changes in the tax code may be possible next year.
As a candidate, Joe Biden released a tax plan that contained several provisions that could affect auto dealers, including:
- A corporate tax increase from 21 to 28% and a new 15% minimum tax on corporations’ book income.
- An increase in the top individual tax bracket from 37 to 39.6%.
- A payroll tax proposal that would subject wage and self-employment income in excess of $400,000 to the Social Security payroll tax (currently, the 6.2% tax ends at $137,700 of wage income).
- Subjecting individuals earning over $1 million to the ordinary income tax rates on their long-term capital gains and qualified dividends.
- Retaining the qualified business income deduction (QBID) for pass-through business income but modifying the rules utilized by real estate investors and including a phaseout of the deduction for taxpayers with income exceeding $400,000.
- Many new programs aimed at the creation or restoration of business operations inside the United States.
- Combining these provisions would mean that dealerships (typically owned through flow-through entities) could see taxes increase by 10% from an effective rate of 29.6 to 39.6% in the next few years. While these proposals will face headwinds and potential amendments in Congress before they become law, it makes sense to consider, when working through year-end tax planning, a potential tax increase in 2021 or 2022. With that in mind, our experts have identified several year-end tax strategy considerations for dealerships.
LIFO inventory and the potential for pickups
Due to supply side slowdowns caused by the COVID-19 pandemic, many dealers are currently concerned with the effect inventory shortages will have on their LIFO reserve. Generally speaking, as inventory levels decrease, the LIFO reserve will also decrease, causing an income pickup by the dealership. This has many dealers asking, “Is LIFO still the method for me?” Before making that decision, the following points should be considered:
- Dealerships that elect off of the LIFO inventory method won’t be eligible to return to it for five years. The entirety of the dealership’s current reserve would be picked up over a four-year period beginning with the year of the method change. This means that electing off LIFO now will cause 25% of a dealership’s reserve to be picked up into income in 2020.
- For dealerships that stay with LIFO inventory, any year-end LIFO pickup in 2020 may be taxed at lower rates than what it might be in 2021 and beyond. Should inventory levels return to a “normal” level in the future (as many dealers expect), the corresponding LIFO deductions would reduce income in years that may be subject to higher tax rates. LIFO is a great cumulative benefit, and to ensure maximized tax savings over the long term, auto dealerships should carefully weigh the long-term ramifications of a change in method.
Timing of income and deductions
One of the oldest rules in tax planning is to defer income and accelerate deductions wherever possible. However, that advice assumes that tax rates will remain static. When tax rates are expected to increase, other alternatives, like the following, should be considered.
- If a dealership typically pays bonuses to owners before year-end, they might consider paying those bonuses in 2021 in order to deduct them against potentially higher tax rates.
- Dealerships should model out foregoing bonus depreciation and Section 179 depreciation on assets with shorter lives. They can apply this strategy on an asset-by asset basis, and it would result in higher depreciation deductions in years that are expected to have higher tax rates.
These strategies may result in a slightly larger cash outlay with 2020 tax returns, but could net out more money in the pockets of the dealership and its owners over the long term.
Estate and succession planning — time could be running out
For the 2020 tax year, the estate tax exemption is $11.58 million for single taxpayers and $23.16 million for married taxpayers filing jointly. However, Joe Biden’s campaign tax plan has proposed reducing the exemption to between $3.5 and $5 million for tax years 2021 and beyond. There is also talk that the current 40% estate tax rate could go back to 45%, a rate that hasn’t been seen since 2009.
A reduction in the exemption could vastly reduce the amount of wealth that can be transferred tax-free at death, making strategies for lifetime gifting important for dealership owners who have the potential for a taxable estate. While no one can currently confirm what estate rules will be, succession planning and the completion of gift transfers prior to the end of 2020 will be an important consideration for dealers. Missing the window to act could be extremely costly.
As your dealership continues to adjust to an ever-changing climate, our experts in tax and business consulting are here to help you achieve the best results possible. If you have any questions about year-end tax planning and possible tax law changes that may be coming in 2021, please contact your Plante Moran advisor.