COMPETING TAX REFORM PROPOSALS (FINAL IN THE SERIES)
Dear Clients and Friends:
A third in a series to clients and friends, this report explains the status of competing tax reform proposals and what appears to be a pivot by President Biden away from former Democrat senator colleagues (Bernie Sanders) . It addresses planning in light of imminent reform, and offers some prognostications- educated guesses. President Biden’s American Jobs Plan involves $2.3 trillion of claimed expenditures for United States’ infrastructure, primarily funded by Corporate tax increases. His $1.8 trillion American Family Plan is composed mainly of social spending funded by tax increases on the “wealthy,” which is the focus of this report. The pivot seems to be a focus on taxing unrealized capital gains on gifts, in trusts, and transfers at death, which potentially expands the tax base by affecting more taxpayers, while leaving the estate and gift tax exemptions and rates alone. In other words, President Biden’s American Families Plan does not address the estate and gift tax exemption or rates, and thus as proposed leaves the exemption at $11.7 million per person and the tax rate at 40%. This stands in contrast to the Senator Sanders’, “ For the 99.5 Percent Act,” which is proposed to reduce the estate tax exemption to $3.5 million, the gift tax exemption to $1 million, and increase the corresponding estate and gift tax rates to as high as 65%.
Since our last report, Congressman Bill Pascrell, Jr. (D-New Jersey) introduced H.R. 2286, which focuses on taxing unrealized gains on gratuitous transfers of property as if sold. It was introduced at the same time that Senator Chris Van Hollen (D-Md), joined by Senators Cory Booker (D-NJ), Sanders, Whitehouse, and Elizabeth Warren (D-Mass), announced the Sensible Taxation and Equity Promotion (“STEP”) Act, which allegedly “addresses the stepped-up basis [at death] loophole” by taxing unrealized gains at death and when making gifts. As written, it would tax unrealized gains on gifts made after December 31, 2020 or testamentary transfers of assets on deaths after that date. The Pascrell bill (H.R. 2286) applies to transfers by gift or on deaths occurring after December 31, 2021, which is viewed as a more reasoned and educated effective date than that of the STEP Act. These legislative measures have various exceptions and limitations, which are beyond the scope of this report other than to mention they will apply to far more people than our current estate and gift tax regime. For example, in one proposal there would only be a $100,000 exemption for unrealized gains inherent in gifts made during life and only a $1 million exemption for gains in assets transferred at death, less the amount of the $100,000 gift exclusion used during life.
It is also important to keep in mind that Senate Finance Committee Chairman Ron Wyden (D-Or) is seeking a “mark- to- market” approach to marketable securities, whereby unrealized gains would be taxed each year. A deduction would be allowed for any loss. Today, gains and losses only occur when they are realized by a sale or exchange. Furthermore, for non-publicly traded property, a penalty would accrue and grow over time for as long as property were held, denying tax deferral on unrealized gains. There will be much debate concerning such a tax by economists, politicians, and academics before this type of proposed legislation becomes law, but one thing is for certain- our current government is out to tax wealth! Commentators believe that compromise will result in one of the following: (1) either no step-up in cost basis at death with heirs inheriting historic basis; (2) a tax on gains as proposed by the STEP Act and H.R. 2286; or (3) the mark-to-market approach advocated by Senator Wyden. It is possible though, that some form of combination of approaches is enacted, including a reduction of the estate and gift tax exemption, as proposed by Bernie Sanders. As a reminder, with certain exceptions, provisions under the Sanders’ For the 99.5% Act are intended to apply in calendar years beginning after the date of its enactment. So, if passed in 2021, it would become applicable to transfers by gift and by death occurring in 2022. The Act, among other provisions, provides for:
• A reduction of the estate tax exemption from its current $11.7 level to $3.5 million. This amount is indexed for inflation.
• A reduction of the gift tax exemption from $11.7 to $1 million, while reducing the annual per person exclusion from $15,000 to $10,000 and $30,000 in total to everyone per year. These amounts are not indexed for inflation.
• A reduction and limitations on the use of generation skipping exempt trusts by reducing the duration of exempt status and the amount of exemption to conform with reduced estate and gift tax exemptions.
• Increased estate and gift tax rates to 45% on amounts over $3.5 million; 50% on amounts over $10 million; 55% over $50 million; and 65% on amounts over $1 billion.
• Elimination of, or restrictions on, a host of other common estate planning tools, trusts, and methods of valuation.
Simultaneously, the Biden Administration has called to increase audits. IRS Commissioner Rettig informed a congressional panel that increasing audits and IRS personnel could generate an additional $175 billion in tax revenues. The agency has lost 15,000 enforcement personnel since 2010.
• President Biden’s proposed The American Families Plan Act focuses on taxing unrealized gains, as does the Van Hollen and Pascrell bills. Senator Wyden’s proposal does the same with an annual wealth tax on financial assets. Pascrell is a member of the House Ways and Means Committee and Wyden is Chair of the Senate Finance Committee. Both are supported by substantial government legislative resources. Chances are high changes will be made to eliminate the “step up” in cost basis rule that eliminates capital gains on death, with or without gain recognition and resulting tax recognition. Taxing unrealized gains without transfers as a Wyden and Warren annual wealth tax would attempt, would be met with substantial Constitutional challenge and substantial administrative cost.
• The Pascrell, Van Hollen, and Wyden proposals tax far more taxpayers with potentially far lower net worth’s than does our current estate and gift tax system.
• Planning to address gain recognition on transfers at death or by gift is quite similar to traditional planning. Use your current means to transfer wealth in advance of tax reform, whether access to that wealth is potentially needed or not.
• The absence of a reduction of the estate and gift tax exemption in President Biden’s The American Families Plan Act could be temporary or fleeting. It is possible that some form of compromise could be enacted, that combines a reduction of the estate and gift tax exemptions, such as exists in Senator Sanders’ bill (For the 99.5 Percent Act), with a carry-over basis regime. That combination has been done before. Gain recognition on gifts and on transfers on death are significant new types of taxes not previously used in the United States, though they are prevalent in other countries, such as Canada and the United Kingdom. As proposed, they would involve greater administrative and taxpayer cost and burden to comply, whereas the infrastructure and taxpayer cost of compliance with the Sanders’ proposals coupled with carryover basis (elimination of the step-up) already exists.
• Given the focus on capital gain recognition on gifts and transfers at death, the concern with gifting low basis assets in advance of tax reform and possible loss of a stepped-up basis at death may no longer be a reason to delay. In fact, only those whose death may be imminent should hesitate.
Planning- What to do Now
• 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.
• 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.
• 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 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