2021 Tax reset: Addressing common client concerns

For many of your clients, 2020 was probably the most confusing year in recent memory when it came to filing their taxes.

A raft of pandemic-related legislation was passed in 2020, beginning with March 2020's $2.2 trillion CARES (Coronavirus Aid, Relief, and Economic Security) Act, followed by December's $900 billion Consolidated Appropriations Act (CAA). Both pieces of legislation contained several federal tax-relief measures that may have applied to your clients as they prepared to file. Some of these provisions were designed to be temporary and applied only to filing year 2020, while others will be extended through 2021 and beyond. This was all further complicated by the passage of the American Rescue Plan Act (ARPA) in March 2021.

With all the moving parts, both individuals and couples filing jointly are likely to have lots of questions about how to "re-set" for 2021 in advance of filing next year.

Here, are some of the issues you may want to cover as you seek to demonstrate your value as an advisor over the next year.

Business deductions

Let's start with small business owners, many of whom are likely to have questions for you.

The widely reported Paycheck Protection Program (PPP) offered Small Business Association (SBA) loans that do not need to be repaid as long as the funds were used at least 60% for qualified payroll costs and the remainder spent on other allowable expenses. "These PPP funds are not taxable income, and the expenses paid with forgiven funds are deductible—a win-win for small businesses," says Robbin E. Caruso, CPA, CGMA, a Partner and the Co-Leader of the National Tax Controversy Department at the international advisory and accounting firm Prager Metis.

The CAA provided for a second round of PPP loans in 2021 with more flexibility for allowable expenses, added Caruso. The SBA also provided Advance Grants of up to $10,000, which are tax-exempt and generally do not have to be paid back. The SBA's Economic Injury Disaster Loans (EIDL), too, provided up to $150,000 to qualifying businesses with favorable repayment terms. The SBA later increased the EIDL available loan amounts to $500,000. In addition, the SBA provided Targeted EIDL Advance funds of up to $10,000 for eligible businesses in low-income communities that do not need to be repaid and will be tax-exempt income for 2021, Caruso said. If your clients participated in the PPP and/or EIDL programs, filing in 2022 is going to be complicated by the impacts of the legislative changes.

Another aspect of the new relief that will apply to the coming year is The Employee Retention Credit (ERC), which is available now to qualifying small businesses that successfully filed for PPP and kept employees on the company's payroll, says Caruso. "The ERC is retroactively available for 2020 for qualifying businesses that received PPP funds," she says. "Businesses cannot use the same payroll dollars to qualify for PPP loan forgiveness and the ERC. The credit is also extended through Dec. 31, 2021 and made more valuable as the ERC offers a maximum credit of $14,000 per employee (up from the maximum credit per employee of $5,000 in 2020)."

Finally, your clients should be aware that pandemic legislation modifies deductions for business meals, from 50% to 100%. This applies from Jan. 1, 2021, through Dec. 31, 2022, according to Caruso.

Medical and sick leave, and unemployment expenses

No discussion of the coronavirus pandemic would be complete without acknowledging the devastating toll the virus has taken on American families. With so many people facing financial peril while caring for sick loved ones, pandemic legislation offered tax provisions to make paid sick and family leave less burdensome for both individuals and small businesses.

Businesses with fewer than 500 employees may be eligible to claim tax credits to reimburse them for the cost of providing sick and family leave to employees as a result of COVID-19. This was extended through March 31, 2021.

Individuals and couples filing jointly who paid significant medical expenses are also eligible for tax relief. The medical expense threshold for itemized deductions is now permanently set at 7.5% of adjusted gross income (AGI), says Caruso. It was set to return to 10% for 2021, but this favorable change to the threshold is now a permanent adjustment moving forward. This means that filers whose unreimbursed medical expenses exceed 7.5% of their AGI may be eligible to receive tax relief when filing this year.

Regarding unemployment, the recent American Rescue Plan Act of 2021 made up to $10,200 of year 2020 unemployment payments tax-exempt for taxpayers (for each spouse if filing a joint return) where 2020 adjusted gross income is less than $150,000, noted Caruso.

Mortgage deductions

The Consolidated Appropriations Act also offered benefits to homeowners. "Tax-exempt treatment has been extended through December of 2025 for up to $750,000 ($375,000 if married filing separately) of cancellation of debt income related to the mortgage debt for a taxpayer's qualified principal residence," says Caruso. This is likely to require a bit of explanation for clients. Essentially, prior to the second round of pandemic legislation, this mortgage debt forgiven or canceled by a lender would be taxed at the filer's ordinary income rate, unless the taxpayer qualifies for another exception (i.e., bankruptcy or insolvency), Caruso said. Now, and through the end of 2025, filers will not have to add this canceled debt to their income for the purposes of filing—meaning that this canceled debt will not be taxed.

Another change instituted through the CARES Act is that, through 2021, filers have the option of itemizing deductions for mortgage insurance premiums. However, Caruso notes that in many cases, taxpayers may receive a more favorable tax break by taking the standard deduction.

Education expenses

The pandemic legislation also provided beneficial write-offs to education expenses that many of your clients may be able to claim. For starters, clients may have been eligible to deduct up to $250 ($500 if married filing jointly) of educator expenses, which now include the costs for protective equipment and supplies to prevent the spread of COVID-19 in educational settings, Caruso said. This would apply to teachers, teacher's aides, counselors and principals who bought personal protective equipment or cleaning supplies for use at schools for kindergarten through grade 12.

While the tuition-and-fees deduction is permanently expired at the end of 2020, says Caruso, in its place, the pandemic legislation increased the phaseout for the lifetime learning credit (LLC) to $80,000 for single filers ($160,000 for those married filing jointly). This means that the tax credit—amounting to up to $2,000 per return—will be available to even more filers this year.

Earned income and child tax credits

Clients who previously did not meet the income threshold to qualify for the Earned Income Tax Credit (EITC) may have been able to claim it in their 2020 taxes because of changes included in the pandemic legislation.

New provisions in the ARPA modified the EITC rules for 2021, making the credit available to more taxpayers filing next year. For instance, the minimum age to claim credit was generally reduced to 19 from 25.

Caruso says, "New relief in the CAA allows taxpayers to use their earned income from 2019 for purposes of calculating their 2020 EITC and CTC." If a filer's 2020 earned income was too low to fully benefit from or qualify for the EITC and/or CTC, the pandemic legislation allows them to use their 2019 income for the purposes of calculating their credit or credits. This means that clients, including those who work in the gig economy, as well as self-employed people, may have claimed the EITC/CTC this year, and they should know that next year, the ARPA allows taxpayers to use either their 2019 or 2021 earned income to calculate these credits for year 2021, she says.

Clients with children may have taken advantage of child tax credits of up to $2,000 per child for year 2020. When filing 2021 tax returns, people earning up to $75,000 ($150,000 if filing jointly) will be eligible to receive an expanded credit amount of up to $3,600 per child, but this, too, is temporary and will not be available the following year unless the provision is extended, Caruso says (see more below).

Retirement accounts and RMDs

You should make your clients aware of two issues relating to their retirement accounts. First, the CARES Act suspended the requirement to take required minimum distributions (RMDs) for 2020, so when clients filed their 2020 tax return, they were not penalized for failing to withdraw the RMD from their IRAs in 2020, Caruso says. "This helped individuals to basically avoid increasing their taxable income, and also it meant that individuals didn't need to remove money from their retirement plans at a time when the markets were initially low due to the crisis," she explains. But clients will need to meet their RMD requirement again by the end of 2021 (unless it's their first distribution, in which case they can defer it for three months to April 1).

Secondly, if your clients made early withdrawals due to a coronavirus hardship from an eligible retirement plan, such as their 401(k) or IRA in 2020, they were not assessed the usual 10% penalty, which applied to withdrawals of up to $100,000. These distributions may be included in income ratably over three years or all in the first year 2020, Caruso says. What's more, she adds, "These amounts that were withdrawn will ultimately be treated as tax-exempt rollover contributions to the extent they're repaid over the next three years." So, in 2020 and the years ahead, your clients need to plan carefully to repay these retirement withdrawals, if they wish to avoid paying tax on them.

Modifications to charitable contributions

Given the toll the pandemic has taken on so many Americans, many of your clients may have increased their charitable giving. If so, pandemic legislation enabled filers to be even more generous in their contributions in 2020.

Those who gave to "qualifying organizations"—meaning those that are "religious, charitable, educational, scientific, or literary in purpose"—were able to claim a $300 "above-the-line" deduction, says Caruso, meaning they didn't need to itemize their giving to benefit as they were required to do in previous years. The CAA extended this provision through year 2021 and increased the amount to $600 for those married filing jointly. The above-the-line deduction, however, ends after 2021 (unless extended). Filers need to keep detailed records to substantiate their charitable giving each year and so that they can itemize the deductions when beneficial over taking the standard deduction, she says.

Helping your clients in an unprecedented year

The bottom line for many of your clients is that filing next year will look different than it did in 2021.

"This is such a unique year, and there have been so many tax law changes, different types of grants, assistance, and credits made available to people," says Caruso. "For the first time, filers' AGI and taxable income may look very different than it has in prior years. So, it won't be the same as what they're accustomed to seeing."

And the same goes for next year: the bottom line is that, given the unique nature of filing in 2021, and the many temporary tax provisions, Caruso recommends clients work with a financial professional who is also deeply familiar with the tax provisions of individual states, which can vary from federal guidelines.

Clients are likely to you look to you to help them navigate this tricky terrain and take advantage of every tax break they're entitled to. As your clients file their taxes after a difficult year, you can position them for financial success moving forward—and strengthen your relationship in the process.

This material is provided for general and educational purposes only, and is not intended to provide legal, tax or investment advice.

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