With the second COVID-dominated tax filing season now well underway, hopefully firms have gotten the kinks out of working remotely and have the technology in place to do so successfully. There are even suggestions that remote working will not disappear after we leave the pandemic behind us.
Rather than looking forward to a smooth tax filing season, however, new issues have emerged to create complications for this tax filing season as well. The tax legislation enacted in response to the COVID pandemic will make its first appearance on 2020 tax returns. Congress also followed its frequent habit of enacting year-end tax legislation that included provisions impacting 2020 tax returns. The Internal Revenue Service, still struggling to deal with tax changes from the Tax Cuts and Jobs Act, the CARES Act, and its own problems from the COVID shutdown, was again faced with a need to make last-minute changes to forms, instructions, and processing software in response to the Consolidated Appropriations Act 2021.
In short, it should be another very interesting tax filing season.
Delayed start. Due to the issues the IRS was facing as a result of the CAA, the service announced that the filing season would not start until Feb. 12, 2021. This is the latest start in recent memory and at least a couple of weeks later than recent years. The IRS has not yet delayed the April 15 tax filing deadline, although they have been requested to do so and that is still a possibility.
In theory, tax return preparation can start ahead of the commencement of filing with the IRS, but it may be more difficult to get clients to submit all of their information if the prospect of a quick tax refund is not a motivator. If the more concentrated filing period is not extended, return preparers may be more reluctant to take on new clients, and more clients may be encouraged to file extensions.
The RRC. New on the 2020 tax return is the Recovery Rebate Credit, where taxpayers can claim an additional credit to the extent they have not received the full credit to which they were entitled either in the first or second round of economic stimulus payments. Return preparers should obtain Notices 1444 and 1444-B from the taxpayer as documentation for the advance payments received.
Since the advance payments were based on 2018 or 2019 tax returns and many taxpayers had lower incomes in 2020 due to COVID, there could be many taxpayers who have not received the full credit to which they are entitled on their 2020 tax returns. Taxpayers who do have a lower income in 2020 may have an additional incentive to file early other than receiving their refund earlier. If the 2020 return is on file with the IRS before an additional economic stimulus is approved under President Biden’s tax proposals, the IRS is likely to use the 2020 income as the basis for the stimulus payment rather than the 2019 income.
Unemployment compensation.Many taxpayers may have received unemployment compensation in 2020 for the first time. They should receive a Form 1099-G documenting what they received. Those benefits are taxable and, unless they elected to have withholding taken out of the benefits or paid estimated taxes during 2020, those taxpayers may find that they are subject to an underpayment of estimated tax penalty.
Many other taxpayers are receiving 1099-Gs for benefits that they did not apply for and did not receive. These victims of identify theft are being encouraged by the IRS to try to get the 1099-Gs corrected by their state unemployment agency. The IRS also says that they should not include benefits shown on the 1099-G if they did not receive them. State unemployment agencies have been overwhelmed with work and it may take them many months to issue corrected 1099-Gs.
Charitable contributions. For 2020 tax returns, the charitable contribution deduction will be an issue not only for itemizers but also for non-itemizers. Many taxpayers not accustomed to taking a charitable contribution deduction may not have maintained good records of donations for the year. Even though the deduction for non-itemizers requires cash donations, the documentation requirements remain the same as for itemizers.
Retirement plan withdrawals. Taxpayers who made penalty-free COVID-related retirement plan withdrawals in 2020 are required to pay taxes on one third of those withdrawals with the 2020 tax return, unless they plan to repay the funds to the plan within the next three years. If taxpayers are uncertain about their ability to repay the funds, it may be better to pay one-third of the tax this year and then file for a refund if they end up able to restore the funds to avoid possible interest and penalties, if they end up unable to repay the funds within three years.
Working from home. Employees working from home during the pandemic are generally not entitled to a home office deduction for unreimbursed employee business expenses. Self-employed persons can generally deduct those expenses. Employees working from home in a different state from their normal place of work may have nexus issues that require filing of a tax return in the state where they worked. A number of states have adopted special COVID nexus rules that say the state will not seek to tax employees only working in a state temporarily due to the COVID pandemic, but not all states have adopted such a provision.
Some states also require employers to reimburse employees for necessary business expenses incurred by the employee while working from home. Those reimbursed expenses should not result in taxable income if they are reimbursed under an accountable reimbursement plan.
Employee Retention Credit and PPP loans. Under the CARES Act, businesses had to choose between either a Paycheck Protection Program loan or the Employee Retention Credit. Under the CAA, employers can now claim both for 2020, as long as it is for different wages. Due to different definitions for wages for each, confusing statutory language, and its retroactive application for 2020, figuring out how much ERC a business might be entitled to may require a very complicated analysis. It may also require IRS guidance to resolve uncertainties under the statutory language.
Paid sick leave and family leave credits. In addition to the ERC, payroll taxes were also reduced in 2020 for the paid sick leave and family leave credits under the Families First Coronavirus Response Act. Calculating these credits will also be an additional burden on 2020 business returns.
Deduction of PPP expenses. The CAA blessed the deduction of expenses paid for with forgiven PPP loans. This will in general be good news for taxpayers. There still could be some complications if those PPP loans are not forgiven until well into 2021 and some owners of pass-through businesses need the basis increase from the forgiven loans to fully utilize the expense deduction.
The SALT deduction cap. The IRS has blessed a state workaround for the SALT deduction cap involving the state taxes being paid by partnerships or S corporations, rather than the owners of those pass-through entities. Under the IRS guidance, taxpayers in states that had already enacted such provisions before the IRS guidance was issued may retroactively follow that guidance back to the date of the state enactment.
While many states will probably now adopt such SALT workaround provisions, only about half a dozen had enacted such provisions prior to the IRS announcement. For taxpayers in those states who in 2020 had state taxes paid through these pass-through entities, tax return preparers can now rely on this IRS guidance for accepting the SALT cap workaround on the 2020 tax return.
Amended returns. Tax legislation in 2020 included several provisions that could result in the need for clients to amend prior years’ tax returns. This included net operating loss carrybacks, the business interest deduction, the limit on losses for pass-through businesses, the Kiddie Tax, qualified improvement property, and the more than 30 expired tax extenders retroactively extended back to 2018. The end-of-the-year CAA legislation added to this list by retroactively changing the depreciation period for rental real property built before 2018 from 40 years to 30 years.
Cryptocurrency transactions. The IRS has moved a question about whether the taxpayer has engaged in cryptocurrency transactions from Form 1040 Schedule 1, where it appeared on the 2019 tax return, to the top of the Form 1040, where it appears on the 2020 return. It will be much harder for taxpayers to “overlook” the question, and the IRS will be watching for the reporting of any related income from any positive responses to the question. The IRS has also had some success in obtaining third-party information from cryptocurrency facilitators about who has engaged in such transactions.
While firms have had a year to adjust to living with COVID, many of the tax law changes related to COVID will be encountered for the first time on 2020 tax returns, creating challenges for taxpayers, tax return preparers, and the IRS alike.
