TAX REFORM: BIDEN ADMINISTRATION TREASURY PROPOSAL
Dear Clients and Friends:
This is a fourth note concerning potential tax reform. The other three can be found in the News & Resources, Hot Topics, section of our website. This note elaborates on President Biden’s American Jobs Plan, by summarizing the relevant tax reform proposals most applicable to our clients. These proposals have now been published by the Department of Treasury, in its General Explanation of the Administration’s Fiscal Year 2022 Revenue Proposals (the “Green Book”) released May 28, 2021. The most significant of these proposals is the expansion of the capital gains tax system to far more circumstances, including recognition of gains on gifts and transfers on death. For example, as proposed an estate of $25 million that includes property with $10 million of appreciation (capital gain), would incur two taxes: (1) a capital gains tax of as high as $4 million and an estate tax of $3,720,000 ($25 million – $11. 7 million – $4 million or $9.3 million x 40%). An estate of $11.7 million that includes property with $10 million of appreciation (capital gain) would be subject to a $4 million capital gains tax, but no estate tax, whereas under current law there would be no tax at all (neither capital gains nor estate tax). Surprisingly, the Green Book does not include a reduction of the estate, gift, and generation skipping tax rates or reduction of related exemptions. This could be a result of a recognition that the estate, gift, and generation skipping tax exemptions are set to automatically reduce to $5 million indexed for inflation from 2018 (projected to be just over $6 million) in 2026. In 2026, on the same $11.7 million estate in the example above, the capital gain tax would be $4 million and the potential estate tax would be an additional $680,000 ($11.7 million – 6 million= $5.7 million, less $4 million deduction = $1.7 x 40%= $680,000). As a result, new systems for taxing appreciated assets (unrealized gains) could be viewed as a way to expand the tax base by capturing a broader spectrum of untaxed wealth that has escaped taxation, in some instances for generations. The Green Book differs from proposals made by Senator Bernie Sanders under the For the 99.5% Act, which increases estate, gift, and generation-skipping taxes, but more closely aligns with proposals under the Sensible Taxation and Equity Promotion Act (“STEP”), H.R. 2286, and proposals by Senator John Wyden to tax wealth by taxing unrealized capital gains, espoused by a number of members of the Senate and House.
Administration Proposal Summary:
The following is a summary of the relevant provisions of the Biden Administration, Department of Treasury, Green Book:
1. Income Tax Increase: The top income tax rate would increase from 37% (40.8% including the net investment income tax) to 39.6% (43.8%) in 2022 on taxable income over $452,700 (single) or $509,300 (joint), and would be indexed for inflation.
2. Qualified Dividend and Capital Gain Tax Increase: Currently, the top income tax rate on qualified dividends and capital gains is 20%. Those within the Administration have advocated for a 28% rate, but the Green Book proposes to tax capital gains just like ordinary income on amounts of income over $1 million ($500,000 if married filing separately); i.e., at the 39.6% rate proposed (43.8% including the net investment income tax). This provision is intended to apply to transactions and dividends after the date of enactment, ostensibly to avoid a taxpayer rush to accelerate income into 2021 and out of 2022. Should this provision become law, and be effective after December 31, 2021, substantial planning related to accelerating gains will occur. The $1 million income level is indexed for inflation.
3. Transfers of Appreciated Property: To confront what some characterize wrongly as a tax loophole and to eliminate a disparity between earnings of the wealthy and low and middle-income taxpayers, the Administration desires to tax the appreciation in property that is gifted or transferred on death. This is not a loophole, but a clear statutory mandate within the Internal Revenue Code. As such, the real intent is to diminish a recognized disparity in our tax system between the wealthy and lower and middle income classes. The degree of exemption is meant to distinguish these classes, which is characterized by the degree of exemption provided. Consistent with tax systems in Canada, the United Kingdom, and others, this proposal is aimed at expanding the tax base by taxing appreciation on gifts and transfers at death that possess in excess of $1 million of gain. Significant noteworthy provisions:
(a) The provisions would apply to transfers in and out of trusts, partnerships, and other non-corporate entities;
(b) A deemed transfer would occur every 90 years by a trust, partnership, or other non-corporate entity holding appreciated property, with the testing period beginning January 1, 1940 (thus, for example, old family trusts created in 1940 or earlier that hold appreciated property would recognize gain December 31, 2030);
(c) A $250,000 per person exclusion for certain tangible personal property (not collectibles) and $1 million exclusion for all other property would apply;
(d) Exclusion amounts would be indexed for inflation and portable between spouses if not used; the $250,000 per person principal residence exclusion would apply; and the $10 million gain exclusion for sales of certain qualifying small business stock would apply;
(e) Exceptions would be made for family businesses and farms;
(f) A 15 year payment plan at fixed rates of interest would be available for the tax caused by transfers at death;
(g) Exclusions would exist for transfers to spouses who are U.S. citizens and charities; and
(h) The tax paid is deductible against any estate tax payable under the estate tax system.
These provisions would apply to gifts and transfers on death occurring after December 31, 2021, and for property owned by trusts and partnerships on or after January 1, 2022.
4. Net Investment Income and Self-Employment Taxes: These additional taxes become convoluted and avoidable in some instances, depending on the choice of entity. For example, self-employment income of an S corporation only applies to salaries deemed reasonable of an owner of an S corporation. All additional profits escape the self-employment tax system. Similarly, profits on certain non-portfolio types of investments escape the net investment income tax system. The Administration’s proposals would subject taxpayers with adjusted gross income over $400,000 to the net investment income tax on gross income or gains from any trade or business not otherwise subject to employment taxes. Limited partners, LLC members, and S corporation shareholders who materially participate in a business would be subject to self-employment tax on their distributable shares of business income, above certain threshold amounts. Rents, dividends, capital gains, and certain retired partner income would be exempt. This change is proposed to be effective after December 31, 2021.
5. Repeal of 1031 Exchanges: The Administration proposes to treat exchanges of real property as sales, subject to a $500,000 per taxpayer deferral exception whereby that level of gain could be deferred until property received in exchange is sold.
6. Carried Interest Treated as Compensation Income: Profits interests of investment partnerships are generally taxable based upon the character of the distributable share of partnership level income (which passes out to them) or gain on sale proceeds. The Administration proposes to tax as ordinary income a partner’s share of income on an “investment services partnership interest” (ISPI) in an investment partnership, regardless of the character of the income at the partnership level. This change in treatment of so called “carried interests” by hedge fund managers has been proposed for many years, as the increase of the ISPI value is directly linked to the performance of services by the manager, which is normally taxed as ordinary income. It would also become subject to self-employment tax. A sale of an ISPI would also be taxed as ordinary income.
Whether tax reform will take shape as Biden or those urging tax reform proposals would like is uncertain. We have already seen a willingness to reduce proposed spending budgets, as moderates appear to be resisting while progressives are pushing, before the midterm elections in 2022. The Democrat Party holds slim control over both the Senate and House. The softness in the budget may be a result of this slim margin of control, with eight senators up for re-election in 2022 in purple states where they won their last race by less than 6%. Voting for significant tax reform could cause the following three to lose their races in 2022:
|Senators Name||State||Last Winning %||Who Won –
Trump or Biden
|Maggie Hassan||New Hampshire||0.1%||Biden by 7.2%|
|Catherine Masto||Nevada||2.4%||Biden by 2.4%|
|Michael Bennet||Colorado||5.7%||Biden by 13%|
Furthermore, three Democrat senators from red or purple states, up for re-election in 2024, would also be in jeopardy if they supported significant tax increases:
|Senators Name||State||Last Winning %||Who Won –
Trump or Biden
|Joe Manchin||West Virgini||3.3%||Trump by 39%!!|
|Jon Tester||Montana||3.6%||Trump by 16%|
|Sherrod Brown||Ohio||6.9%||Trump by 8%|
With those six senators almost certain not to support an estate tax increase or other major tax increase, the Democrat victories in the Georgia senate races become meaningless. New Senators Warnock and Ossof of Georgia, won with less than 1% of the vote. (Biden won the state with less than 0.3%.) It is suggested that neither would dare vote for major tax increases.
It is not anticipated that any Republican senator will support major tax reform like that proposed in H.R. 2286, STEP, or Biden’s American Jobs Plan, as these proposals have been written. There is, however, always the chance that Susan Collins from Maine, a state Biden carried, or Linda Murkowski from Alaska, who dislikes Trump, could become independent and caucus with the Democrats or that proposals increase taxes far less than proposed.
Though the budget is decreasing from the level originally proposed, it is likely some measure of tax reform and tax increases will occur. It is also clear that “wealth” is the target with only the measure of taxation and targeted wealth being uncertain. Flexible planning therefore appears to be the correct approach. There is a push by some members of Congress, like House Ways and Means Committee chairman Richard Neal (Mass.-D), to hold public hearings from stakeholders who would be affected, like the AFL-CIO, the U.S. Chamber of Commerce, Teamsters, and Truckers to gain the support needed. An example cited by Neal is gaining Manchin support by providing Union jobs to West Virginia. White House aides cite polls showing that the majority of Americans support raising taxes on the rich and corporations.
Observations and Planning
Our focus is helping clients navigate the uncertainty of tax reform within a climate of substantial uncertainty, while providing flexibility. Our advice is to pursue planning with sufficient flexibility to tolerate alternative paths. For example, currently it appears that transfers of appreciated property valued at up to $11.7 million (less the value of prior taxable gifts) to gifting trusts (for a spouse, other family members, or both) is an optimum strategy, since it would confront both the possibility of the reduction of the estate tax exemption and also recognition of capital gains on property appreciation at death. A trust of this nature can often be structured to permit effective recission within nine months, with assets returning to the donor, and it can be structured to permit the exchange of high basis (low appreciation) assets for low basis (high appreciation) assets, should either approach be optimum and preferred in the future. Other matters providing flexibility and family access to financial resources are commonly also incorporated into trusts of this type. Additional planning thoughts:
- Consider consolidating financial assets in entities, like limited liability companies or family limited partnerships. Doing so can promote varies benefits and efficiencies. It can make prepositioning of assets between spouses easier, and can allow for prompt and efficient transfer on short notice. For example, transfers can be made over a weekend when markets, banks, and broker-dealers are closed, by relatively simple assignment documentation.
- Consider utilizing currently available estate and gift tax exemptions by gifting in trust to family members, such as spouses or children. Spouses can gift to each other in trust while utilizing their exemptions, provided the so called Reciprocal Trust Doctrine is avoided. A discussion on this topic begins on the first page of our Fall 2020, Client Update newsletter, which can be found on our website. If not done prior to passage of gain recognition and before potential reduction of the estate, gift, and generation-skipping tax exemption on or before its scheduled reduction in 2026, it will not be possible without having to recognize any unrealized gains in property transferred.
- Homes or other real property can be transferred into qualified personal residence trusts or spousal access trusts, utilizing exemptions while still providing access, possession, and use.
- Intrafamily sales can be used to shift growth out of taxable estates, while providing a continued source of cash flow and financial security through promissory notes that bear nominal interest. These sales can be structured without capital gains taxes on sales.
- Consider intrafamily sales to defer recognition of gain using installment sales strategies that would potentially avoid accelerated tax if new laws require gain recognition on transfers of property by gift or at death. Since the inherent gain is now reflected in a deferred payment installment promissory note, this strategy may defer accelerated recognition on death.
- Consider charitable lead trusts and grantor retained annuity trusts which benefit from our current low interest rate environment.
- When implementing these and other trust strategies, consider elective measures and disclaimer provisions which effectively permit the rescission of taxable transfers within limited periods of time to unwind these transactions should the laws not evolve as predicted.
As with all tax reform, we cannot predict with certainty what if any provisions will be retroactive, prospective, or as of the date of enactment of legislation. However, we can help our clients navigate these and other unknowns while evaluating the impact of alternatives. We also cannot guarantee that our work and your decisions will be finalized before the effective dates of tax reform. We believe tax reform is inevitable and the aim is to tax the wealthy, with the measure of who is wealthy becoming a lower threshold. Time is of the essence. At this point our best guess is that tax reform will be prospective and effective January 1, 2022, but with a risk that it is effective as of the date of enactment. We do not believe legislation will be retroactive but cannot guarantee it won’t. We can, however, help you confront these risks.
We are pleased to be of service. Should you have any questions or comments, please feel free to contact us.
Joseph C Kempe, Esquire