Depending on your particular level of cynicism, tax professionals either have just kicked off tax season 2023 or are merely continuing the tax season that began in January 2020. Regardless of your viewpoint, the past few years have been an undeniably rough stretch for tax pros. We’ve been tasked with implementing the Tax Cuts and Jobs Act of 2017 and various legislative responses to the Covid-19 pandemic, while a series of delayed tax deadlines have left many of us feeling as though we haven’t taken our foot off the gas in years.
But relief is coming. With a divided Congress effectively ending the chance for any meaningful tax legislation for a while, and with the pandemic (hopefully) under control, some sense of normalcy should return come April 19.
That’s not to say that this coming tax season will be a picnic. While 2022 will be remembered most for the legislation that fell short—President Joe Biden’s Build Back Better agenda largely didn’t come to pass—the tax law for 2022 returns doesn’t look the same .A number of tax breaks for individuals expired at the end of 2021. On the business tax side of things, two long-awaited tax increases finally kicked in when the calendar turned to 2022.
Out With the Old
I’m not breaking any news by saying this, but many individual clients judge their tax pro’s peformance on a single factor: How does the size of their refund or tax liability compare to the previous year’s?
When a client’s taxable income, filing status, and family size remains fairly constant from year to year, well … that’s not necessarily an unreasonable approach. Unless, that is, the tax law changes dramatically from one year to the next, which is exactly the scenario in which we find ourselves when preparing 2022 tax returns.
Remember that 2021 brought the American Rescue Plan, which heaped a bevy of benefits on certain individual taxpayers. Many of those benefits expired at the end of 2021, and the impact for this year will be significant.
To illustrate, let’s look at a hypothetical family of five, with two parents and three children under the age of 6. For both 2021 and 2022, the family has adjusted gross income of $100,000, pays $8,000 in childcare costs for their youngest child, and contributes $600 to charity. Assume further that the family neither owed a federal tax liability in 2021 nor received a refund. Rather, they broke even, as the sum of their federal income tax withholding and tax credits exactly wiped out any tax liability.
In 2021, the child tax credit reached a high of $3,600 per child and was fully refundable. As a result, our hypothetical family could reduce their tax liability by $10,800. Fast forward to 2022, and that same family’s credit would max out at $6,000 ($2,000 per child). Thus, our family of five will owe $4,800 more than they did in 2021, solely due to a change in tax policy.
The news gets worse. The enhanced dependent care credit that was in place for 2021 is gone. Instead of receiving a $4,000 credit as they did in 2021 (50% of maximum expenses taken into account of $8,000 for one child), our family will receive a $1,050 credit in 2022 (35% of the maximum expenses taken into consideration of $3,000). That’s $2,950 of additional tax the family will owe in 2022 compared to the prior year.
If that weren’t enough, individuals claiming the standard deduction can’t deduct up to $600 of charitable contributions in 2022, as they could in 2021. If our family is among the 93% of taxpayers who no longer itemize their deductions, they won’t benefit from the $600 they donated to charity in 2022. Assuming their effective tax rate is 20%, that will cost another $120.
Even though nothing changed from year to year, our family went to having a tax liability of $7,770 in 2022 from owing $0 to Uncle Sam in 2021. That’s going to sting.
In With the New
The bad news isn’t limited to individual clients. When the clock struck midnight on Dec. 31, 2021, two tax increases that were enacted in 2017 as part of the TCJA finally took effect, and their impact will be felt now.
Before 2022, businesses could deduct expenses for research and experimentation immediately. For expenses incurred after Dec. 31, 2021, however, businesses must capitalize and amortize those R&E expenses over five years (15 years for foreign expenses). As a result, many research-intensive businesses that never generated taxable income may suddenly find themselves with a bill.
To illustrate, imagine a start-up business with $100,000 in revenue, $50,000 in deductible expenses, and $100,000 in R&E expenses. In 2021, the business would have generated a tax loss of $50,000. Under the new rules, the same business must capitalize the $100,000 in R&E costs and will generate taxable income in 2022 as a result.
Changes have arrived in computing a business’s deductible interest expense as well. The TCJA brought a new interest deduction limitation to the tax law, requiring certain businesses to cap their deduction for business interest expense at 30% of adjusted taxable income.
In computing adjusted taxable income from 2018 through 2021, businesses could increase taxable income by any depreciation or amortization expense deducted during the year—in many cases significantly increasing the 30% limitation. With the arrival of 2022, businesses no longer can increase adjusted taxable income by depreciation or amortization expenses. As a result, many capital-intensive businesses with significant depreciation expenses will lose some or all of their interest expense deduction.
Talk It Out
As tax professionals, our clients look to us to keep up with the changing winds of tax policy. They may be blissfully unaware that the material changes discussed in this article will adversely affect their 2022 tax returns. It’s critical that tax pros schedule time in the coming weeks to communicate to clients what’s new for tax year 2022 and how these changes may impact their tax picture. After all, the only thing a client dislikes more than owing a tax liability is getting surprised by one.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Tony Nitti is a tax partner in the private tax group of Ernst & Young’s National Tax Department, where he chairs the S corporation and Section 1202 subgroups.
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