Introduction
President Biden released his administration’s proposed budget for fiscal year 2022. While spending focuses on infrastructure, clean energy, etc., it includes a host of proposed tax changes affecting individuals and corporations. Some of the significant tax changes that many taxpayers hoped wouldn’t happen, like Senator Van Hollen’s taxation on transfers and death, are included. Those changes would transform tax planning, raise significant revenues, and might have an impact on the reduction of wealth concentration in America.
Your Next Tax Move
While planning your next chess move, consider that there is often many changes from proposals to final legislation so it remains premature to assume that the proposals will be what will be enacted. That said, taking protective action before new tax legislation becomes effective may prove worthwhile. But caution remains in order. Senator Van Hollen’s proposal still has a retroactive effective date back to January 1, 2021. So planning steps you take now to avoid costly tax changes, might themselves trigger tax costs. So immediate action, with caution and flexibility, should be evaluated with your advisor team. Some have already labeled the proposal negatively as constituting excessive spending and high taxes. So what might actually get enacted is unclear. Very important to current planning steps, is what will be the effective date of any new changes.
Proposed Individual Tax Increases
The American Families Plan increases income taxation of high-income individuals, restricts tax deferred like-kind exchanges (swamps of real estate that avoid current income taxation a sale would trigger), and much more. Some of the proposals include:
Higher Tax Rates: The top income tax rates will be bumped up from 37% to 39.6%. While some had expected that this increase would apply to taxpayers earning over $400,000, the proposal applies to income over $509,300 for married filing joint taxpayers, and to income over $452,700 for single taxpayers. While this is a rate increase, it is not clear that for 2.6% of a rate differential triggering gains that might be unnecessary will be advantageous.
Capital Gain Rates Might Double: Consistent with proposals that have been buzzing capital gains (e.g. sale of stock, investment real estate, etc.) of those with adjusted gross income over $1 million will be taxed at 37%. That is about double the current 20% capital gains rate. This could have dramatic changes in investment, retirement, and other planning. It might also warrant immediate planning. If you are planning on selling investment real estate, a family business, or diversifying out of a concentrated stock position, it might be beneficial to sell now before the rates double! Evaluate options with all your advisers. It might be helpful to create forecasts reflecting various tax and economic scenarios to determine what might be worth pursuing. But be careful. What might the effective date of any such change? If this change is enacted, future planning could be dramatically changed. Taxpayers might forecast and plan sales and income for a decade or longer into the future. Then, actions can be taken to control income realization to stay below the $1 million threshold and avoid doubled rates. This might include using installment sale treatment, charitable remainder trusts and more. Harvesting gains and losses may take on a very different approach then it has had historically.
New Realization Tax on Transfers: Perhaps the most dramatic change is to make the transfer of property by gift, and on assets owned at death trigger events for capital gains. This will transform planning. If you want to make gifts of appreciated assets (for example to use some of the current $11.7 million transfer tax exemption just in case that is reduced in the future) be wary that those transfers might trigger capital gains if made after the effective date of the new legislation. But what date might that be? So, immediately action might be worthwhile. But you might discuss with your advisers using techniques to unwind the transfers to avoid an unintended capital gains cost on transfers. Some advisers integrate provisions into irrevocable trusts that are a common recipient of gift transfers that permit one or more persons (trustee, one primary beneficiary, or all beneficiaries) to disclaim the transfers thereby (hopefully!) unwinding the transfers. For income tax purposes it may be possible to rescind a transaction during the same tax year if trip up over the effective date. This is all complex and there are many views of each potential options, so review them with your tax advisers. Consider what this type of change might do to future planning? If your estate will pay capital gains on all appreciation in assets you own on death, the historic bias of holding assets until death so that the capital gains would disappear (with a basis adjustment from what you paid for an asset to the fair value of the assets at death). That may prove costly. Instead, a totally new planning approach may become the rage. You might have your wealth adviser and/or CPA forecast income and tax consequences out for years or even decades. It might prove advantageous for some to realize some amount of gain each year before death to avoid the higher almost 40% tax on death. Estate planning documents might benefit from amendments to permit this type of planning.
Tax on Trusts and Entities: There is another facet to the above realization regime. Gain on unrealized appreciation also would be recognized by a trust, partnership, or other non- corporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years, with such testing period beginning on January 1, 1940. The first possible recognition event for any taxpayer under this provision would thus be December 31, 2030. This might suggest that if you have created irrevocable trusts (or create them now to try to avoid a reduction in exemption which might not be incorporated into new legislation) a capital gains tax could be due on all appreciation as soon as 2030! What planning options might exist? Might trustees be able to distribute appreciated assets to beneficiaries to avoid that tax? Will trust agreements permit that? Will lots of grandchildren be driving red hot sports cars in 2031?
Social Security Taxes: Another proposal is to coordinate the net investment income and self-employment taxes. Historically, high income taxpayers who earned income from a closely held business, e.g. a physician from her medical practice, paid themselves a more modest salary that was subject to Social Security taxes. The remaining profits were withdrawn as a distribution to owners that was not subject to those taxes. The savings, especially over years of work, could add up. The proposal is that all passthrough business income (e.g. S corporations, limited liability companies, partnerships) of high-income taxpayers will be subject to either the net investment income tax or Social Security taxes. That might result in the restructure of closely held business entities, revisions to governing documents (e.g. partnership agreements) and changes in how profits, salary and other payments are made. This may have ripple effects on valuations, buy-out agreements, and more.
Carried Interests: Hedge fund principals may face higher taxes as carried interests will be taxed as ordinary income instead of capital gains, about a doubling of the rates.
More Audits: The IRS will receive more funding to expand enforcement. That might mean lots more audits.
Business Tax Increases
The American Jobs Plan proposes several corporate tax changes including the increase corporate income tax rate to 28% from its current 21%. For those who restructured family and closely held business entities to regular or “C” corporation form to take advantage of lower corporate tax rates, this change might have them evaluate switching to an S corporation or other format. That, however, is not so simple as there can be costs in restructuring C corporations. Be certain to review any plans with all of your tax advisers before taking any steps. Moving forward, the decision as to which type of business structure and choice of entity may change from what it has been since the 2017 tax law changes. Be careful as well to review your estate planning documents, especially trusts. If you change a C corporation to an S corporation your irrevocable trusts will require special provisions to avoid tainting the tax favored status of an S corporation (the pass through of income to owners instead of paying a corporate tax). There is a laundry list of other changes, but those are beyond the scope of this preliminary discussion.