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Advisor Insights

Prepping Clients for COVID-19 Tax Season

Here's how to address upcoming taxes for a variety of client situations.

The coronavirus brought major changes to our lives. And, if you're one of the lucky ones, the worst of it has been isolating, missing vacations, and staying cooped up at home.

Of course, the COVID-19 pandemic had--and continues to have--a disruptive impact on businesses and employment. That is about to spill over into this year’s tax season for many clients. In some cases, your clients will need to free up a meaningful amount of cash for higher taxes due.

Here’s a look at several scenarios to discuss with your clients.

Home Office
Many people were forced to work from home during 2020. So, does that mean they can deduct home-office expenses? The answer depends on whether the worker is an employee or an independent contractor (self employed). For employees, there is no tax deduction. In the past, unreimbursed employee business expenses were deductible as a miscellaneous itemized deduction. Unfortunately, since 2018, miscellaneous itemized deductions are no longer allowed.

For those who are self-employed, a home-office deduction might be possible. To qualify for a home-office deduction, the taxpayer must itemize, and the office (room or part of a room) must:

  • Be the primary place of business, and 
  • Be used regularly and exclusively for business

If your clients can claim home-office expenses, be sure they keep proper records.

 Expenses related to a home fit into one of three categories:

  • Expenses related solely to the home office. This would include repairs for the office, such as painting; dedicated security in the office; and so on. These expenses are 100% deductible. 
  • Expenses related to the entire house. This would include mortgage interest, utilities, and depreciation. These expenses are deductible proportionately based on the space of the office versus the entire home--either based on square footage or number of rooms. So, if a home office is 200 feet out of a 2,000 square-foot house, that would be 10%. That same home office could be one room out of eight rooms. That would be 12.5%. Thus, to maximize deductions, the home-office deduction would include 12.5% of "entire house" expenses. 
  • Expenses related solely to other than the home office. This would include pool cleaning, repairs in the master bedroom, and so on. These expenses are not deductible.

If it looks like your clients can qualify to claim home-office deductions, be sure they work with a qualified CPA. Beside calculating home-office expense deductions, the CPA might recommend the "simplified" method. Under this method, no recordkeeping is required. The deduction is simply $5 per square foot, up to a maximum of 300 square feet.  

State Residency for Tax Purposes
Working remotely due to COVID-19 restrictions can result in state tax consequences. This can occur when the remote workplace (home or other location such as a cabin or beach house) is in a state other than that of the usual office. Let's say that your client lives and works in Arizona. When your client had to work remotely, she decided to work from her vacation home in Hawaii. As a result, your client worked the major part of the year in Hawaii. Income from personal services is taxed where services are performed. Thus, Hawaii could be entitled to state taxes on the wages earned in that state.

There is some good news. Many states will not claim rights to taxes if the employee is working outside the usual state not due to personal choice. Using the previous example, if the office was reopened in June but the employee decided to remain in Hawaii through the end of the year, Hawaii would only tax the last six months of the year (if Hawaii allows the exception for the earlier months).

Unfortunately, some states will treat remote work due to COVID-19 as a personal choice--meaning that the state will still tax wages earned for a company based in their state even if the worker is performing the services in a different state. This includes states such as New York, Arkansas, Connecticut, Delaware, Nebraska, and Pennsylvania.

Also, note that even if your client's remote work state (Hawaii in the above example) were to tax your client's income, the state of the employer's residence (Arizona in the above example) would still levy tax on the full amount of income. To rectify the double state tax predicament, there's an "other state" tax credit. This ensures that the taxpayer only pays tax to one state on the same income (albeit at the higher rate of the two).

PPP Loans
For many business, Payroll Protection Program loans were a lifeline. And for those businesses that applied for and received forgiveness on the loan, it adds another nuance to tax planning. Businesses that received PPP loans can exclude the amount forgiven from federal taxable income without having to eliminate deductions for expenses paid with the loan proceeds. By receiving the loan proceeds as nontaxable without reducing deductions, businesses truly get a full tax-free benefit from PPP loans. But there may be an additional layer of complication. Some states disallow the deduction of expenses paid with forgiven PPP proceeds--in essence, making the forgiven portion of the loan taxable. For clients who didn't expect to pay state taxes, this could be a tough pill to swallow.

Unemployment Benefits
If your client has collected unemployment benefits, it's likely that no withholding was taken out. Your client might not be prepared for this. Most states also tax unemployment benefits, although 15 states (including California, New Jersey, and Tennessee) exempt the income from taxation. (Note that a bill has been introduced to exempt up to $10,200 of unemployment benefits in 2020.)

Tax Penalties
The IRS requires at least 90% of the year's tax liability be paid ratably during the year. Absent qualifying for an exception, failure to meet this minimum payment results in a tax penalty due by April 15 of the following year. If your client has not withheld (or made quarterly tax payments) on all income, the tax due could exceed 10% of the total liability, resulting in a penalty. For clients who are continuing to receive unemployment benefits, be sure to recommend they talk to their CPA about their options for paying tax throughout the year as required. For example, they can elect to withhold federal taxes on unemployment income, but the withholding rate is only 10% and, thus, might not be enough to avoid penalties. Other alternatives would be to pay quarterly tax payments or increase withholding on other income.

Conclusion
You can't control whether or not your clients end up owing taxes in April. But, armed with this information, you will be able to tip them off to potential issues or opportunities. And, of course, make sure they are working with qualified CPAs.

Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and founder of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively run her advisory business, from which Morningstar acquired the Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar or of Rowling & Associates LLC.