The Biden administration has released the Green Book, which details what they wish for as changes to the way income, and specifically capital gains are taxed. Here is a quick summary of the proposed changes:
- The top marginal individual income tax rate rises from 37% to 39.6%.
- The top individual income tax bracket begins at $452,700, down from $523,601.
- Capital Gains are taxed as ordinary income for taxpayers with incomes over $1 million.
- Carried Interest are taxed as ordinary income for taxpayers with incomes over $400,000.
- Any transfer of property (including gifts and at death) will be treated as a sale of the property and the capital gains will be taxed, with gains over $1 million being taxed at the new 39.6% rate(plus the 3.8% net investment income tax).
There is an exclusion for transfers to a spouse or to charity.
Tax on illiquid assets can be paid over 15 years.
Tax on a family business is deferred so long as the family operates it.
Transfers to trusts and partnerships triggers the capital gains tax.
Trusts that have been in existence for more than 90 years will be taxed,
There will be no discounts for fractional interest in an asset.
There is an estate tax deduction for the capital gains tax paid.
- S-Corp stockholders, partnership interest holders and other taxpayers who receive pass-through business income over $400,000 will have to pay either the net investment income tax (3.8%) for passive investors in the business or the Self-Employment Contributions Act tax (12.4%) if they materially participate in the business.
- Like-kind exchanges for real estate is limited to $1 million annually.
The effective date of these changes is December 31, 2021, but there is some talk to having the law retroactive to “the date of announcement” of April 28, 2021.
These proposed changes are a fundamental change to more than a century of tax law. The change will layer an increased capital gains tax on top of any gift, estate or generation-skipping transfer tax due and will eliminate the step-up in basis in estates. The assets in the estate (that are not used to pay the capital gains tax and exceed $3.5 million) pay both capital gains and estate tax.
There is also proposed annual reporting requirement for trusts not only a balance sheet and income statement but also an accounting of the trust’s activities and operations during the year, if the trust has assets over $1 million or income over $20,000.
What is missing in the Green Book, which has been banded about, is proposal to make gift taxes retroactive to January 1, 2021, elimination of Grantor Retained Annuity Trusts and other split interest transfer techniques.
What does the Future hold?
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So, look for an accelerating shift in planning away from gift and estate tax planning and towards income tax planning. This has been ongoing since 2012, but it will dominate. Holding appreciated assets until death in order to achieve a stepped up basis will no longer be a viable strategy. Small businesses and professional firms changing the way they manage their income with more funding of retirement accounts rather than investing in the equity of the company, and fewer owning their place of business, so driving up commercial rents. Installment sales will become more popular, especially where the annual installment payment keeps the seller below the $1 million annual income tax level. Use of Qualified Opportunity Zone Funds, Charitable Lead Trusts, Charitable Remainder Trusts and other alternative strategies will flourish.
All this means that Planning will need to be done years, if not decades, in advance of possible transactions involving businesses involving illiquid assets, such as agricultural land, even thought there is a 15 year period pay the tax, a huge drag on the profitability of these businesses.
Also, considering the deferral of gains recognition for family businesses, look for family members who are forced into “material participation” in the business, and a sharp decline in M & A transaction involving closely held businesses, in order to avoid triggering the capital gains tax. Far from breaking up concentrations of wealth, this will force the further concentration of wealth, but on a family basis.
Even if these proposals do not come to pass, there is an automatic taxes changes looming on the horizon. This is because the tax changes made in 2017 under President Trump only last for 10 years, that is the laws revert back in 2026, only five years away. The proposal will have the useful effect of focusing client’s immediate attention on tax planning which they otherwise would defer until too late.