Also see: CPA Sample Client Letter: 2021 Year-End Tax Planning for Individuals
              An In-Depth Look: 2021 Year-End Tax Planning for Businesses

2021 Year-End Tax Planning Guide For Individuals. Client Letter Included.

(Parker Tax Publishing November 1, 2021)

As Congress engages in intense negotiations over an ever-changing rotation of tax provisions in a $1.85 trillion reconciliation bill, practitioners are busy working with clients to identify strategies they can use to minimize their 2021 tax liability. This first installment of Parker's annual two-part series on year-end tax planning recaps the year's major changes affecting individual taxpayers and the implications of those changes for year-end tax moves.

Practice Aid: Use Parker's Sample Client Letter as a template or just sign your name at the bottom. See Our Sample Client Letter (Individuals).

Introduction

As 2021 winds to a close, it's time to start thinking of any last-minute strategies that could benefit clients. This year's task is complicated not only by an unusually fluid and uncertain legislative backdrop, but also many Covid-related tax relief provisions that were enacted at the end of 2020 in the Consolidated Appropriations Act, 2021 (CAA 2021) and in March 2021 in the American Rescue Plan (ARP) Act of 2021.

CAA 2021 extended some key tax provisions, including a permanent reduction of the medical expense adjusted gross income threshold from 10 percent to 7.5 percent. The ARP responded to the ongoing pandemic by, among other things, providing a third round of economic impact payments and extending and enhancing the child tax credit, the earned income tax credit, the child and dependent care tax credit, and the premium tax credit.

On the current legislative front, a bipartisan infrastructure bill (featuring several significant tax provisions) that passed the Senate is being held up the House pending the results of negotiations among Democrats on a much larger tax and spending package. It remains to be seen what tax provisions will make it into the final bill and whether such a bill can win approval of tight Democratic majorities in both houses. As of press time, the most likely tax provisions include: (1) a 3 percent income tax surcharge on incomes in excess of $10 million (5 percent on incomes above $25 million); (2) broadening the 3.8 percent Net Investment Income Tax (NIIT) to apply to active trade or business income from pass-through entities of high-income taxpayers; (3) a 15 percent corporate minimum tax; (4) a 1 percent tax on corporate stock buybacks; and (5) a large increase in the IRS's enforcement budget. Proposed increases in individual, corporate, and capital gain tax rates appear to be off the table, as are new limits on the Code Sec. 199A deduction and a "billionaires income tax". The fate of a proposal to lift the $10,000 cap on the SALT deduction is unclear. Given the fluid nature of the negotiations and uncertainty about whether the bill will ultimately pass, practitioners may find it difficult to factor potential changes into year-end planning - at least until the shape of the final bill takes clear form.

A detailed discussion of 2021's major changes and planning opportunities under existing law follows.

Individual Tax Brackets Up Slightly

After being adjusted for inflation, individual tax brackets for 2021 have increased slightly. For 2021, the top tax rate of 37 percent applies to incomes over $523,600 (single and head of household), $628,300 (married filing jointly and surviving spouse), and $314,150 (married filing separately). However, high-income taxpayers are also subject to the 3.8 percent net investment income tax on the lesser of net investment income or the excess of modified adjusted gross income over the following threshold amounts: $250,000 for married filing jointly or qualifying widow(er), $125,000 for married filing separately, and $200,000 in all other cases. High-income taxpayers are also subject to the .9 percent additional Medicare tax on certain income that is more than the following threshold amounts: $200,000 for single filers and head of household, $250,000 for joint filers, and $125,000 for married-filing-separately. The types of income subject to this tax include Medicare wages, self-employment income and railroad retirement compensation. For taxpayers subject to one or both of these additional taxes, there are certain actions (discussed below) that can be taken to lower a taxpayer's adjusted gross income and mitigate the damage of these additional taxes. It's worth noting that these taxes are not deductible.

For married couples, employers do not take a spouse's self-employment income or wages into account when calculating the .9 percent additional Medicare tax withholding for an employee. If a married couple's income will exceed the $250,000 threshold in 2021, and they have not made enough tax payments to cover the additional .9 percent tax, a Form W-4 should be filed with the taxpayer's employer before year end to have an additional amount deducted from the client's wages. Otherwise, the couple may get hit with underpayment of tax penalties.

Standard Deduction versus Itemized Deductions

At the outset, it's important to determine if a client has enough deductions to itemize or if there are steps that can be taken which will give a taxpayer enough deductions to itemize. For 2021, the standard deduction amounts are: $12,550 (single); $18,800 (head of household); $25,100 (married filing jointly); and $12,550 (married filing separately). An additional standard deduction amount of $1,350 applies for taxpayers who are 65 or older or blind. This additional amount is increased to $1,700 if the individual is also unmarried and not a surviving spouse. If the taxpayer is 65 or older and blind, the deduction is doubled.

If a client's itemized deductions in 2021 will be close to his or her standard deduction amount, practitioners should evaluate whether alternating between bunching itemized deductions, such as charitable contributions or medical expenses, into 2021 and taking the standard deduction in 2022 (or vice versa) could provide a net-tax benefit over the two-year period.

Filing Status

Generally, a return filed as married filing separately is not beneficial for tax purposes. However, in some unique cases, such as when one party earns substantially less or when one party may be subject to IRS penalties for issues relating to that person's tax reporting, it may be advantageous to file as married filing separately. Additionally, if one spouse was not a full-year U.S. resident, an election is available to file a joint tax return where such joint filing status would otherwise not be available. Depending on each individual's taxable income, this could help the couple reduce their joint tax liability.

Income, Deductions, and Exclusions from Income Relating to Taxpayer's Residence

Home Office Expenses: The fact that the COVID-19 pandemic has caused more individuals to work from home means that more clients will be asking about the home-office deduction. For employees, expenses relating to working from home are not deductible. The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the deductibility of such expenses when it suspended the deduction for miscellaneous itemized expenses that was available before 2018. However, for self-employed individuals, tax deductions are still available. Because individuals are limited to a maximum $10,000 deduction for state income and property taxes, allocating a portion of these tax expenses to the portion of a taxpayer's home used for business, can increase deductions for these amounts that would otherwise be lost.

Mortgage Interest Deduction: For clients who sold a principal residence during the year and acquired a new principal residence, the mortgage interest deduction may be limited. For mortgages of more than $750,000 obtained after December 14, 2017, the deduction is limited to the portion of the interest allocable to $750,000 ($375,000 in the case of married taxpayers filing separately). For a mortgage on a principal residence acquired before December 15, 2017, the limitation applies to mortgages of $1,000,000 ($500,000 in the case of married taxpayers filing separately) or less. However, for clients operating a business from home, an allocable portion of the mortgage interest is not subject to these limitations.

Deductions for Interest on Home Equity Debt: Interest on home equity debt may be deductible where a client used that debt to buy, build, or substantially improve his or her home. For example, interest on a home equity loan used to build an addition is typically deductible, while interest on the same loan used to pay personal expenses, such as credit card debt, is not. Thus, it's important to document the portion of the debt for which an interest deduction is taken.

Gain or Loss on the Sale of a Home: If a client sold his or her home this year, up to $250,000 ($500,000 for married filing jointly) of the gain on the sale is excludible from income. However, this amount is reduced if part of the home was rented out or used for business purposes. Generally, a loss on the sale of a home is not deductible. But again, if a portion of the home was rented or was otherwise used for business, the loss attributable to that portion of the home is deductible.

Exclusion from Gross Income of Discharge of Qualified Principal Residence Indebtedness: Under Code Sec. 108(a)(1)(E), gross income does not include the discharge of indebtedness of a taxpayer if the debt discharged is qualified principal residence indebtedness and is discharged before January 1, 2026.

Treatment of Mortgage Insurance Premiums as Qualified Residence Interest: Under Code Sec. 163(h)(3)(E), taxpayers can treat amounts paid during 2021 for qualified mortgage insurance as qualified residence interest. The insurance must be in connection with acquisition debt for a qualified residence. This provision was previously scheduled to expire at the end of 2020 but instead was extended through 2021 by CAA 2021.

Exclusion from Gross Income of Cancelled Qualified Real Property Business Indebtedness

Under Code Sec. 108(a)(1)(D), taxpayers can exclude from gross income a discharge of qualified real property business indebtedness which applies to real property used in a trade or business, such as a home office, and is secured by such real property and meets certain other qualifications.

Charitable Contributions

Subject to certain limits, individuals who itemize their deductions may generally deduct charitable contributions to qualifying charitable organizations, although the usefulness of the charitable contribution deductions was reduced when the TCJA increased the standard deduction so it was greater than many individuals' itemized deductions. However, CAA 2021 extended through 2021 temporary changes to the charitable deduction rules that applied in 2020. Thus, individual taxpayers can claim an above-the-line deduction of up to $300 ($600 for married taxpayers filing jointly) for cash contributions to qualifying charitable organizations made during 2021. Contributions of noncash property, such as securities, do not qualify for this deduction. Note that an increased penalty of 50 percent applies for an overstatement of this deduction.

For individuals making charitable contributions that exceed their standard deduction, the deductible amount is limited based on the individual's adjusted gross income (AGI). These limits typically range from 20 percent to 60 percent of AGI and vary by the type of contribution and type of charitable organization. For example, a cash contribution made by an individual to a qualifying public charity is generally limited to 60 percent of the individual's AGI. Excess contributions may be carried forward for up to five tax years.

However, for 2021, CAA 2021 permits electing individuals to deduct up to 100 percent of their AGI for qualified contributions made during 2021. Qualified contributions are contributions made in cash to qualifying charitable organizations.

As with the new limited deduction for nonitemizers, cash contributions to most charitable organizations qualify, but cash contributions made either to supporting organizations or to establish or maintain a donor advised fund, do not. Nor do cash contributions to private foundations and most cash contributions to charitable remainder trusts

Donating appreciated assets, such as stock, to a charity can also help a client reap a bigger tax deduction. Generally, the higher the appreciated value of an asset, the bigger the potential value of the tax benefit. By donating appreciated assets, such as stock, a client can avoid the capital gains tax that would otherwise be due if the stock were sold and instead pick up a nice charitable contribution deduction. For example, if a client owns stock with a fair market value of $1,000 that was purchased for $250 and the client's capital gains tax rate is 15 percent, the capital gains tax on the sale would be $113 ($750 gain x 15%). By donating that stock instead of selling it, a client in the 24 percent tax bracket has an ordinary income deduction worth $240 ($1,000 FMV x 24% tax rate). So the client saves the $113 in capital gains tax that would otherwise be generated on the sale of the stock and that amount goes to the charity instead. Thus, the after-tax cost of the gift of appreciated stock is $647 ($1,000 - $240 - $113) compared to the after-tax cost of a $1,000 cash donation which would be $760 ($1,000 - $240). However, it's important to also keep in mind that tax deductions for contributions of appreciated long-term capital gain property may be limited to a certain percentage of adjusted gross income depending on the amount of the contribution and the type of property contributed.

Finally, if a client has an individual retirement account and is 70 1/2 years old and older, he or she can make a charitable contribution directly from the IRA. This is more advantageous than taking a distribution and making a donation to the charity that may or may not be deductible, depending on whether the taxpayer is itemizing deductions. By making the donation directly from an IRA to a charity, the client eliminates having the IRA distribution included in his or her income. This in turn reduces adjusted gross income (AGI) and, because various tax-related items, such as the medical expense deduction or the taxability of social security income or the 3.8 percent net investment income tax, are calculated based on AGI, the reduced AGI can potentially increase medical expense deductions, reduce the tax on social security income, and/or reduce any net investment income tax.

Medical Expenses, Health Savings Accounts, and Flexible Savings Accounts

Considering how many individuals were affected by the COVID-19 pandemic, especially those that required hospitalization, deductions relating to medical expenses will likely be a big issue on 2021 tax returns. For 2021, medical expenses are deductible as an itemized deduction to the extent they exceed 7.5 percent of adjusted gross income. As was previously mentioned, the threshold was set to increase to 10 percent for 2021 but was permanently reduced to 7.5 percent by CAA 2021.

To be deductible, medical care expenses must be primarily to alleviate or prevent a physical or mental disability or illness. Thus, the cost of vitamins or a vacation taken to relieve stress and anxiety don't count, but hospitalization and long-term care expenses, as well as other treatments relating to a COVID-19 diagnosis, do qualify.

Deductible medical expenses include amounts paid for health insurance premiums, out-of-pocket costs for medicine, and amounts paid for transportation to get medical care. Deductible medical expenses also include amounts paid for personal protective equipment (e.g., masks, hand sanitizer and sanitizing wipes), amounts paid for qualified long-term care services, and premiums paid for a qualified long-term care insurance contract. Qualified long-term care services are necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, rehabilitative services, and maintenance and personal care services that are required by a chronically ill individual, and must be provided pursuant to a plan of care prescribed by a licensed health care practitioner. To be deductible as a medical expense, qualified long-term care insurance premiums must meet certain criteria (e.g., the contract must be guaranteed renewable) and the deduction for such premiums is limited to an amount that is based on the taxpayer's age before the close of the tax year.

Practitioners should consider whether it might be advantageous for a client, who has not already done so, to contribute to a health saving account (HSA) if he or she does not already have one. These tax-advantaged accounts can help an individual who has a high-deductible health plan (HDHPs) pay for medical expenses. Amounts contributed to an HSA are deductible in computing adjusted gross income. These contributions are deductible whether the client is itemizing deductions or not. Distributions from an HSA are tax free to the extent they are used to pay for qualified medical expenses (i.e., medical, dental, and vision expenses). For 2021, the annual contribution limits are $3,600 for an individual with self-only coverage and $7,200 for an individual with family coverage.

If a client works for an employer who offers a Flexible Spending Account (FSA), and the client has not already signed up for an FSA account, it's worth encouraging the client to do so. This will allow him or her to pay dependent care or medical and dental bills with pre-tax money. And the FSA can be used to pay qualified expenses even if the employer or employee haven't yet placed the funds in the account. While health FSA funds can be used to pay deductibles and copayments, they cannot be used for insurance premiums. The maximum amount that can be set aside in 2021 is $2,750. Additionally, while FSAs previously had a modified use-it-or-lose-it policy, meaning employees could carryover over a limited amount of unspent funds if the FSA plan allowed it, CAA 2021 temporarily allows a "full" carryover of unspent funds, if permitted under the FSA plan.

Tax-Free Disaster Relief Payments under Section 139

The Victims of Terrorism Tax Relief Act of 2001 enacted Code Sec. 139, a little-known or used provision under which employers can compensate employees tax-free for extra expenses incurred due to the COVID-19 pandemic. This could include expenses incurred to set up a home office or to rent a place in which to quarantine or even for medical care. Under Code Sec. 139(a), gross income does not include any amount received by an individual as a qualified disaster relief payment. The term "qualified disaster relief payment" means any amount paid to or for the benefit of an individual:

(1) to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster;

(2) to reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or repair or replacement of its contents to the extent that the need for such repair, rehabilitation, or replacement, is attributable to a qualified disaster; or

(3) by a federal, state, or local government, or agency or instrumentality thereof, in connection with a qualified disaster in order to promote the general welfare.

In Rev. Rul. 2003-12, the IRS notes that Code Sec. 139 codifies (but does not supplant) the administrative general welfare exclusion with respect to certain disaster relief payments to individuals. According to the IRS, this exclusion from income applies only to the extent any expense compensated by such payment is not otherwise compensated for by insurance or otherwise. Additionally, qualified disaster relief payments do not include qualified wages paid by an employer, even those that are paid when an employee is not providing services.

The term "qualified disaster" includes a disaster determined by the President to warrant assistance by the federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. Since President Trump declared the COVID-19 pandemic a national emergency under the Robert T. Stafford Disaster Relief and Emergency Assistance Act, the provisions of Code Sec. 139 could apply to payments received by individuals from their employers to compensate the employee for additional expenses incurred as a result of the pandemic.

Education-Related Tax Items

There are several education-related tax deductions, credits, and exclusions from income that practitioners need to consider for clients who either attend, or have children who attend, eligible educational institutions.

Tax-Free Distributions from Qualified Tuition Programs: A Code Sec. 529 qualified tuition plan is a tax-advantaged investment vehicle designed to encourage saving for the future education expenses of the plan beneficiary. Tax-free distributions from a Code Sec. 529 qualified tuition program (QTP) of up to $10,000 are allowed for qualified higher education expenses. Qualified higher education expenses for this purpose include tuition expenses in connection with a designated beneficiary's enrollment or attendance at an elementary or secondary public, private, or religious school, i.e. kindergarten through grade 12. It also includes expenses for fees, books, supplies, and equipment required for the participation in certain apprenticeship programs and qualified education loan repayments in limited amounts. A special rule allows tax-free distributions to a sibling of a designated beneficiary (i.e., a brother, sister, stepbrother, or stepsister). As a result, a 529 account holder can make a student loan distribution to a sibling of the designated beneficiary without changing the designated beneficiary of the account. However, if the total QTP distributions to a designated beneficiary exceed the adjusted qualified higher education expenses of that beneficiary for the year, a portion of those distributions is taxable to the beneficiary. Code Sec. 529(c)(6) also provides that an additional 10 percent penalty tax generally applies to a taxable distribution from a QTP.

Deduction for Eligible Teacher Expenses: A deduction from gross income is available for eligible teacher expenses of up to $250 paid during 2021. If spouses are filing jointly and both were eligible educators, the maximum deduction on the joint return is $500. However, neither spouse can deduct more than $250 of his or her qualified expenses. Qualified expenses include unreimbursed expenses paid for personal protective equipment, disinfectant, and other supplies used for the prevention of the spread of COVID-19 in the classroom.

Exclusion from Income for Savings Bond Interest: If a client paid qualified higher education expenses during the tax year and also redeemed a qualified U.S. savings bond, the interest on the bond is excludible from income if the taxpayer's modified adjusted gross income level is below certain thresholds. Those thresholds are between $83,200 - $98,200 for single and head-of-household filers and $124,800 and $154,800 for married filing jointly or a surviving spouse.

Education Credits: A client who pays qualified education expenses, and has modified adjusted gross income below $80,000 or $160,000 (for joint filers) may be eligible for an American Opportunity Tax Credit of up to $2,500 per year for each eligible student. Above those income thresholds, a partial credit may be available. The amount of the credit for each student is computed as 100 percent of the first $2,000 of qualified education expenses paid for the student and 25 percent of the next $2,000 of such expenses paid. Additionally, a Lifetime Learning credit may be available in an amount equal to 20 percent of so much of the qualified tuition and related expenses paid during the tax year (for education furnished during any academic period beginning in such tax year) as does not exceed $10,000. However, the expenses taken into account for this credit cannot be the same as expenses taken into account for the American Opportunity Tax Credit. The credit is phased out for taxpayers with modified adjusted gross income between $80,000 and $90,000 ($160,000 and $180,000 for joint filers).

Exclusion from Income for Repayment of Student Loan Debt: Gross income does not include any amount which would otherwise be includible in gross income by reason of the discharge of a student loan occurring after December 31, 2020, and before January 1, 2026.

Alternative Minimum Tax

The TCJA decreased the odds of a taxpayer being hit with the alternative minimum tax (AMT) as it increased the AMT exemption and the AMT phase-out thresholds. However, it can still be an issue for higher-income clients. For 2021, the AMT exemption is $73,600 for a single filer, $114,600 for married filing jointly or surviving spouse, and $57,300 for married filing separately. The exemption begins to phase out by an amount equal to 25 percent of the amount by which alternative minimum taxable income exceeds $1,047,200 in the case of married individuals filing a joint return and surviving spouses and $523,600 in the case of unmarried individuals and married individuals filing separate returns. As a result, high-income taxpayers with household incomes above those thresholds, with large amounts of itemized deductions or significant AMT income from exercising stock options, could be at risk for the AMT.

If a taxpayer has a Schedule C business, allocating mortgage interest or property taxes to the taxpayer's Schedule C business will prevent those amounts from being added back and increasing the taxpayer's AMTI.

Qualified Business Income Deduction

Under the qualified business income (QBI) tax break in Code Sec. 199A, a 20 percent deduction is allowed against qualified business income from sole proprietorships, S corporations, partnerships, and LLCs taxed as partnerships. The deduction is available to both itemizers and non-itemizers. The rules that apply to individuals with taxable income at or below $164,900 ($329,800 for joint filers; $164,925 for married individuals filing separately) are simpler and more permissive than the ones that apply to individuals with taxable income above those thresholds. The deduction phases out entirely when taxable income exceeds $214,900 (single, head of household, and married filing separately) and $379,800 (joint filers).

The QBI deduction does not apply to a "specified service trade or business," which is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architecture services are specifically excluded from the definition of a specified service trade or business.

Deductions for Excess Business Losses

Under Code Sec. 461(l), excess business losses of a noncorporate taxpayer are disallowed for tax years beginning after December 31, 2020, and before January 1, 2027. An excess business loss for the tax year is the excess of aggregate deductions attributable to a client's trades or businesses over the sum of aggregate gross income or gain plus a threshold amount. The threshold amount for 2021 is $262,000 or $524,000 for joint returns. Excess business losses that are disallowed are treated as a net operating loss carryover to the following tax year.

Life Events

For clients with divorces pending at the end of the year, practitioners may want to project the differences in a final tax bill based on filing a joint return or filing as married filing separately. For clients that divorced during the year, head of household filing status, with its increased standard deduction, is appropriate if the client has dependents living at home for more than half of the year and the client paid more than half of the upkeep of the home. For clients who will be changing their name as a result of a change in marital status (or for any other reason), the Social Security Administration (SSA) must be notified. Similarly, the SSA should be notified for a dependent whose name has been changed. A mismatch between the name shown on the tax return and the SSA records can cause problems in the processing of tax returns and may even delay tax refunds.

On the other hand, if a spouse died during 2021, the client can still use married filing jointly as the filing status. While the year of death is the last year for which a joint return can be filed with a deceased spouse, the client may be eligible to use the head-of-household filing status next year or the year after that if he or she is considered a "surviving spouse." A surviving spouse is one (1) whose spouse died during either of the two tax years immediately preceding the tax year; and (2) who maintains as a home a household which constitutes for the tax year the principal place of abode (as a member of such household) of a dependent who is a son, stepson, daughter, or stepdaughter of the taxpayer, and with respect to whom the clients is entitled to a dependency exemption deduction for the years in which such exemption deductions are available. Even if the client does not qualify as a surviving spouse, he or she may nevertheless qualify as a head of household if the applicable requirements are met.

2021 Recovery Rebate

The ARP added Code Sec. 6428B to provide a refundable tax credit (i.e., 2021 recovery rebate) in the amount of $1,400 per eligible individual. An eligible individual was any individual other than (1) a nonresident alien, (2) a dependent of another taxpayer, and (3) an estate or trust. Under Code Sec. 6428B(e)(1), the term "dependent" has the same meaning given the term by Code Sec. 152 and thus - unlike the first two rounds of payments - included a qualifying relative. The 2021 recovery rebate began phasing out starting at $75,000 of adjusted gross income (AGI) for an individual ($112,500 for heads of household and $150,000 in the case of a joint return or surviving spouse) and was completely phased out where an individual's AGI is $80,000 ($120,000 for heads of household and $160,000 in the case of a joint return or surviving spouse).

The 2021 recovery rebate is not includible in gross income. It does not reduce a client's refund or increase the amount tax owed if the taxpayer received more than he or she should have based on the taxpayer's adjusted gross income. It also does not affect income for purposes of determining eligibility for federal government assistance or benefit programs.

Child Tax Credit

The ARP significantly expanded the child tax credit (CTC) available to qualifying individuals by: (1) increasing the credit from $2,000 to $3,000 or, for children under 6, to $3,600; (2) increasing from 16 years old to 17 years old the age of a child for which the credit is available; and (3) increasing the refundable amount of the credit so that it equals the entire credit amount, rather than having the taxpayer calculate the refundable amount based on an earned income formula.

The refundable credit applies to a taxpayer (in the case of a joint return, either spouse) that has a principal place of abode in the United States for more than one-half of the tax year or is a bona fide resident of Puerto Rico for such tax year.

Special phase-out rules apply to the excess credit available for 2021 (i.e., either the $1,000 excess credit or, for children under 6, the $1,600 excess credit). Under these modified phase-out rules, the modified adjusted gross income threshold is reduced to $150,000 in the case of a joint return or surviving spouse, $112,500 in the case of a head of household, and $75,000 in any other case. This special phase-out reduction is limited to the lesser of the applicable credit increase amount (i.e., either $1,000 or $1,600) or 5 percent of the applicable phase-out threshold range.

Under Code Sec. 7527A, individuals with refundable child tax credits can receive advance payments equal to one-twelfth of the annual advance amount, thus potentially receiving up to $300 per month for children under 6 and $250 per month for children 6 years and older. These payments are made from July 2021 through December 2021. In essence, a taxpayer can receive one-half of the total child tax credit in the last six months of 2021 and the other half of the credit after filing his or her tax return.

Earned Income Credit

The ARP added Code Sec. 32(n), which expands the universe of individuals eligible for the earned income tax credit (EITC) in 2021 while also increasing the amount of the credit available.

For workers without qualifying children, the applicable minimum age to claim the EITC (i.e., the childless EITC) is reduced from 25 to 19 (except for certain full-time students) and the upper age limit for the childless EITC is eliminated. In addition, the childless EITC amount has been increased as a result of ARP (1) increasing the credit percentage and phase-out percentage from 7.65 to 15.3 percent, (2) increasing the income at which the maximum credit amount is reached from $4,220 to $9,820, and (3) increasing the income at which the phase out begins from $5,280 to $11,610 for non-joint filers. Under these parameters, the maximum EITC for 2021 for a childless individual is increased from $543 to $1,502. The ARP also repealed Code Sec. 32(c)(1)(F), which prohibited an otherwise EITC-eligible taxpayer with qualifying children from claiming the childless EITC if he or she could not claim the EITC with respect to qualifying children due to a failure to meet child identification requirements (such as having valid social security number for qualifying children).

The ARP also amended Code Sec. 32(d) to allow, for tax years beginning after December 31, 2020, a married but separated individual to be treated as not married for purposes of the EITC if a joint return is not filed. Thus, the EITC may be claimed by the individual on a separate return. This rule only applies if the taxpayer lives with a qualifying child for more than one-half of the tax year and either does not have the same principal place of abode as his or her spouse for the last six months of the year, or has a separation decree, instrument, or agreement and doesn't live with his or her spouse by the end of the tax year.

The ARP also increased the amount of disqualified investment income that an individual can have and still claim the EITC. For 2021, the EITC may not be claimed if an individual has disqualified investment income of more than $10,000 (up from $3,650 in 2020).

Finally, the ARP allows taxpayers in 2021, for purposes of computing the EITC, to substitute their 2019 earned income for their 2021 earned income, if 2021 earned income is less than 2019 earned income.

Dependent Care Assistance Tax Benefits

The ARP provided several changes to dependent care assistance programs (DCAPs). It added Code Sec. 21(g), which provides a number of favorable changes to tax benefits relating to dependent care assistance, including: (1) making the child and dependent care tax credit (CDCTC) refundable; (2) increasing the amount of expenses eligible for the CDCTC; (3) increasing the maximum rate of the CDCTC; (4) increasing the applicable percentage of expenses eligible for the CDCTC; and (5) increasing the exclusion from income for employer-provided dependent care assistance.

Generally, a taxpayer is allowed a nonrefundable CDCTC for up to 35 percent of the expenses paid to someone to care for a child or dependent so that the taxpayer can work or look for work. Under Code Sec. 21(g)(1), the dependent care credit is refundable for 2021 if the taxpayer has a principal place of abode in the United States for more than one-half of the tax year. In addition, Code Sec. 21(g)(2) increases the amount of child and dependent care expenses that are eligible for the credit to $8,000 for one qualifying individual and $16,000 for two or more qualifying individuals.

For 2021, Code Sec. 21(g)(3) increases the maximum credit rate from 35 to 50 percent and amends the phaseout thresholds so they begin at $125,000 instead of $15,000. At $125,000, the credit percentage begins to phase out, and plateaus at 20 percent. This 20-percent credit rate phases out for taxpayers whose adjusted gross income is in excess of $400,000, such that taxpayers with income in excess of $500,000 are not eligible for the credit.

The ARP also increased the exclusion for employer-provided dependent care assistance from $5,000 to $10,500 (from $2,500 to $5,250 in the case of a separate return filed by a married individual) for 2021.

Finally, in Notice 2021-15 and Notice 2021-26, the IRS clarified that DCAP benefits that would have been excluded from income if used during the tax year ending in 2020 or 2021, as applicable, remain eligible for exclusion from the participant's gross income and are disregarded for purposes of applying the limits for the subsequent tax years of the employee when they are carried over from a plan year ending in 2020 or 2021 or are permitted to be used pursuant to an extended claims period.

Premium Tax Credit

Code Sec. 36B provides a health insurance subsidy through a premium assistance credit for eligible individuals and families who purchase health insurance through the Health Insurance Marketplace, also known as the "Exchange." The provision is the result of the Patient Protection and Affordable Care Act (PPACA). The premium assistance credit is refundable and payable in advance directly to the insurer on the Exchange. Individuals with incomes exceeding 400 percent of the poverty level are normally not eligible for these subsidies. However, the ARP eliminated that cap for tax years beginning in 2021 or 2022 and allows anyone to qualify for the subsidy. In addition, the provision limits the percentage of a person's income paid for a health insurance under a PPACA plan to 8.5 percent of income. Thus, individuals who buy their own health insurance directly through the Exchange are eligible to receive increased tax credits to reduce their premiums.

In addition, the ARP provided a special rule under which a taxpayer who has received, or has been approved to receive, unemployment compensation for any week beginning during 2021 is treated as a taxpayer who is eligible for the premium assistance credit. Further, for such a taxpayer, any household income in excess of 133 percent of the poverty line is not taken into account in determining the premium tax credit.

Sick and Family Leave Equivalent Credits for Self-Employed Individuals

Certain self-employed individuals are eligible for refundable tax credits equal to the qualified sick leave equivalent amount and qualified family leave equivalent amount with respect for wages paid before October 1, 2021. The term ''eligible self-employed individual'' means an individual who regularly carries on any trade or business within the meaning of Code Sec. 1402 and would qualify to receive paid sick or family leave during the tax year under the Emergency Paid Sick Leave Act (EPSLA) and the Emergency Family and Medical Leave Expansion Act (EFMLEA) if the individual were an employee of an employer (other than himself or herself).

Compliance Tip: The qualified sick and family leave equivalent tax credits are calculated on Form 7202, Credits for Sick Leave and Family Leave for Certain Self-Employed Individuals. The total amount is then entered on Schedule 3 (Form 1040), line 12b.

In general, the term ''qualified sick leave equivalent amount'' means, with respect to any eligible self-employed individual, an amount equal to: (1) the number of days during the tax year (but not more than the applicable number of days) that the individual is unable to perform services in any trade or business referred to in Code Sec. 1402 for a reason with respect to which such individual would be entitled to receive sick leave multiplied by (2) the lesser of (i) $200 ($511 in the case of any day of paid sick time described in Pub. L. 116-127, Sec. 5102(a)(1), (2), or (3)) or (ii) 67 percent (100 percent in the case of any day of paid sick time described in Pub. L. 116-127, Sec. 5102(a)(1), (2), or (3)) of the average daily self-employment income of the individual for the tax year.

The term ''qualified family leave equivalent amount'' generally means, with respect to any eligible self-employed individual, an amount equal to the product of: (1) the number of days (not to exceed 50) during the tax year that the individual is unable to perform services in any trade or business referred to in Code Sec. 1402 for a reason with respect to which such individual is entitled to receive paid leave, multiplied by (2) the lesser of (i) 67 percent of the average daily self-employment income of the individual for the tax year, or (ii) $200.

For the period beginning on April 1, 2021, and ending on September 30, 2021, up to 10 additional days are provided for purposes of determining the qualified sick and family leave equivalent amounts. During this period, the EPSLA is applied as if it provided paid leave for an employee seeking or awaiting the results of a diagnostic test for, or a medical diagnosis of, COVID-19 and such employee has been exposed to COVID-19 or is unable to work pending the results of such test or diagnosis, or the employee is obtaining immunization related to COVID-19 or recovering from any injury, disability, illness, or condition related to such immunization. Any day taken into account in determining the qualified sick leave equivalent amount for the period beginning on April 1, 2021, and ending on September 30, 2021, cannot be taken into account in determining the qualified family leave equivalent amount for the same period.

The term ''average daily self-employment income'' means an amount equal to: (1) the net earnings from self-employment of the individual for the current tax year or, if elected, the prior tax year, divided by (2) 260. The term ''applicable number of days'' means the excess (if any) of 10 days over the number of days during the tax year (but not more than the applicable number of days) that the individual is unable to perform services in any trade or business referred to in Code Sec. 1402 for a reason with respect to which such individual would be entitled to receive sick leave during the tax year pursuant to EPSLA if the individual were an employee of an employer (other than himself or herself).

If an eligible self-employed individual received qualified sick leave wages from his or her employer, the individual's qualified sick leave equivalent amount is reduced (but not below zero) to the extent that the sum of the qualified sick leave equivalent amount and the qualified sick leave wages received exceeds $2,000 ($5,110 in the case of any day any portion of which is paid sick time described in Pub. L. 116-127, Sec. 5102(a)(1), (2), or (3).

Residential Energy Credits

Taxpayers may be eligible for residential energy credits for 2021 if they placed certain property in service during the year. The residential energy efficient property that qualifies for the credit under Code Sec. 25D equals the applicable percentage of the cost of certain qualified property installed on or used in connection with the taxpayer's home. Qualifying properties are (1) solar electric property, (2) solar water heaters, (3) fuel cell property, (4) small wind turbines, (5) geothermal heat pumps, and (6) qualified biomass fuel property expenditures paid or incurred in tax years beginning after December 31, 2020. The applicable percentages are: (1) 30 percent in the case of property placed in service after December 31, 2016, and before January 1, 2020; (2) 26 percent in the case of property placed in service after December 31, 2019, and before January 1, 2023; and (3) 22 percent in the case of property placed in service after December 31, 2022, and before January 1, 2024. This credit does not apply to property placed in service after December 31, 2023.

In addition, for property placed in service after 2010 and before 2022, Code Sec. 25C provides a nonbusiness energy property credit for (1) 10 percent of the cost of qualified energy efficiency improvements installed during the year, and (2) the amount of the residential energy property expenditures paid or incurred by the taxpayer during the year. Qualified energy efficiency improvements include the following qualifying products: (1) energy-efficient exterior windows, doors and skylights; (2) roofs (metal and asphalt) and roof products; and (3) insulation. Residential energy property expenditures generally include: (1) energy-efficient heating and air conditioning systems, and (2) water heaters (natural gas, propane, or oil).

There is a lifetime limit of $500 on the total amount of nonbusiness energy property credits that may be claimed. In addition, the amount of the credit taken with respect to windows cannot exceed $200. The following additional limitations also apply to the nonbusiness energy property credit: (1) $300 for any item of energy-efficient building property; (2) $150 for any furnace or hot water boiler; and (3) $50 for any advanced main air circulating fan.

The residential energy efficient property credit and the nonbusiness energy property credit are computed and reported on Form 5695, Residential Energy Credits.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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