A great degree of uncertainty surrounds proposed tax policy changes expected from the Biden administration. However, during the 2020 campaign, President Biden provided some insights on his tax legislative agenda from which to approach this uncertainty through proactive and flexible planning.
It is certain that we can expect some degree of tax increase to address rising deficits from the pandemic stimulus, the need to fund spending for infrastructure and a renewed focus on inequality when it comes to income. However, passage of the most progressive of tax policy changes does not appear likely in 2021 due to the slim majority Democrats hold in the Senate and upcoming mid-term elections. The Democratic majority can employ the Budget Reconciliation process to overcome a filibuster and pass tax legislation with just 51 votes.
The path of least resistance would be a repeal of the Tax Cuts and Jobs Act of 2017 (TCJA) for those families making more than $400,000 (individuals making more than $200,000), as this is a mere reversion to prior law. This would result in increasing the corporate tax rate and highest income tax brackets and lowering the gift and estate tax exemption.
It is not likely that we will see major tax changes until the latter half of this year. Treasury officials recently commented that tax policy is not a near term priority. Although some commentators are concerned that proposed tax legislation may be retroactive, that is not generally favored. Tax legislation is generally enacted prospectively, but the door is certainly open for tax increases later this year. There is some concern that new tax legislation will be applied retroactively – that is as of the date of introduction or back to the first of the year (Jan. 1, 2021). Rarely are tax increases applied retroactively. Given the current economic downturn due to the pandemic and higher unemployment, introducing tax increases on a retroactive basis seems unlikely. Keep in mind that changing some tax policies can also be achieved via revisions to tax regulations, which do not require the approval of Congress. Tax regulations are not generally implemented on a retroactive basis unless their specific purpose is to address abusive tax transactions.
The key question remains: what actions should we take in 2021 in anticipation of tax increases? Below, we delve into various aspects of contemplated tax policy, examine the proposed changes compared to current tax law and offer insight and opportunities to mitigate potential adverse tax consequences.
Proposed Reduction of Gift & Estate Tax Exemption
Current Tax Law: $11.7 million gift and estate tax exemption; reverts to $5 million (adjusted for inflation) after 2025.
Proposed Policy Change: Potential reduction of estate tax exemption to $3.5 million (or lower), coupled with higher estate tax rates.
If the gift and estate tax exemption is lowered to pre-TCJA levels, then significantly more families will be faced with paying federal estate tax. If your taxable estate is above federal estate tax exemption amounts, understanding your estate tax liability is critical.
Before any significant wealth shifting strategies are implemented, there must be enough retained wealth and income to support your lifetime goals and desired lifestyle. Once this goal is achieved, various wealth transfer strategies can be implemented to move excess wealth – and future growth on the assets you transfer – out of your taxable estate.
Tax Mitigation Opportunities for Gift & Estate Tax
- Fund a GRAT to transfer excess growth of appreciating assets while minimizing gift and estate taxes.
- Consider gifting to flexible trust structures which address the possibility of retroactivity with appropriate language to allow for “unwinding” the gifting transaction.
- Disclaimer planning. Permit a designated beneficiary of a trust to disclaim on behalf of all trust beneficiaries. The designated beneficiary will then have nine (9) months to properly disclaim the gift and, if done so, the gifted assets would be returned to the donor without using any of the donor’s lifetime gift exemption.
- Planning with qualified terminable interest property (QTIP) elections. A married individual could make a gift to an irrevocable trust for the benefit of his or her spouse (a U.S. citizen) that would qualify for the marital deduction if a QTIP election is subsequently made. If a QTIP election is not made, the gifted property would instead pass to a non-qualifying trust for the benefit of the spouse resulting in usage of the donor spouse’s lifetime exemption. The donor spouse now has flexibility to make a QTIP election or forego the election during the following calendar year when the gift tax return is due, after determining whether the reduced lifetime gift and/or GST exemption amount was enacted retroactive to Jan. 1, 2021.
- Utilize a formula transfer clause. By using a formula clause, the donor could make a gift of a fractional interest of property or assets where the numerator is the donor’s available gift and estate tax exemption on the date of the gift, and the denominator is the fair market value of the gifted assets. If the lifetime exemption amount is retroactively reduced, the formula should be “self-correcting” so that the donor only gifts an amount equivalent to the donor’s available exemption on that date.
- Intra-family loans. Use of an intra-family loan can facilitate the transfer of assets during 2021. Interest rates continue to be at historically low levels. The AFR midterm rate for February 2021, for example, is 0.562%. The contemplated gift could instead be structured as an intra-family loan, which could be forgiven at a later date, thereby resulting in a gift if the exemption continues at current levels, or maintain its character as a loan if the lifetime exemption is reduced retroactively.
Basis Step–Up at Death Elimination
Current Tax Law: As of date of death, the cost basis of assets is “stepped up” to fair market value (FMV), resetting the tax basis to FMV.
Proposed Policy Change: Eliminate basis step-up at death resulting in the recipient having carryover basis.
The Biden Administration’s 2021 Proposed Tax Policy suggests eliminating the step-up in basis on the campaign trail but did not provide much detail. More recently, Treasury Secretary Janet Yellen indicated there were “plans to explore” changes to the basis step-up rules. However, several open questions remain:
- Would certain assets be exempt from carryover basis (e.g., farms or primary residences)?
- Would death qualify as a realization event or would the recipient receive carryover basis?
- Would a certain amount be exempt from carryover basis?
Eliminating the basis step-up and converting to a carryover basis regime would be a large and complex undertaking impacting far more individuals and families than the federal estate tax. This proposal is less likely to pass in the near term given the slim majority in the Senate. Unity within the Democratic party would be required to eliminate the basis step-up at death with a single moderate Democrat holding a veto power. This is a high bar considering some Senate Democrats are moderate and up for mid-term elections in 2022.
Tax Mitigation Opportunities To the Possible Elimination of Basis Step-Up at Death
- If basis step-up remains, consider maintaining low-basis assets in your estate, especially if your estate does not exceed the exemption amount and you are well into retirement.
- Work with your team of advisors to analyze using the basis step-up rules and the risks associated with continuing to hold low-basis assets in a rising tax environment.
- Trust vehicles should incorporate flexibility to swap assets in and out of the trust depending on income tax projections once final rules and regulations are implemented.
- Assets within a portfolio should properly align with goals. Under current law, low basis assets are useful for philanthropic and future wealth transfer goals. If basis step-up is eliminated, consider prioritizing low-basis assets for charitable giving.
Individual Income Tax
Current Tax Law: 37% top individual ordinary income tax rate.
Proposed Policy Change: Increase the top individual ordinary income tax rate to 39.6% for families making more than $400,000 ($200,000 for individuals).
There is a significant probability that income tax rates will increase for those making more than $400,000, as rates are at a historical low. The proposed income tax increase is relatively small and would return it to 2013-2017 levels.
Tax Mitigation Opportunities To Combat Changes To Individual Income Tax
- Consider options to accelerate income
- Revisit elections on deferred compensation plans
- Exercise stock options
- Fully fund 401(K) plans and IRAs
- Convert traditional IRA into a Roth IRA
- Make charitable gifts directly from IRA making use of the Qualified Charitable Distribution (QCD). Individuals may make up to a $100,000 QCD directly from an IRA. By employing a QCD, the distribution is made directly from the IRA and is not taken into income by the donor thus avoiding a spike in income levels which could result in being thrust into the higher tax brackets.
- Tax Efficient Trust Distributions: A trust beneficiary’s individual income tax rate may often be lower than a trust’s compressed tax rates, as a trust’s highest tax bracket (37%) kicks in when income reaches $12,950. Trusts also pay the 3.8% Net Investment Income Tax (NIIT) when they reach that level. If a trust is not distributing all of its income this year to family beneficiaries, consider whether it makes sense to make current income distributions to certain family beneficiaries (based on family circumstances and the terms of the trust document) and whether those income distributions can be made tax efficiently.
Increased Tax Rate on Long-Term Capital Gains & Qualified Dividends
Current Tax Law: 20% maximum capital gains tax rate (+ 3.8% Net Investment Income Tax).
Proposed Policy Change: Increase capital gains tax rate for those making more than $1 million to 39.6% (+ 3.8% Net Investment Income Tax).
A near doubling of tax rates on qualified dividends and long-term capital gains may be an uphill battle for the administration. Assessing the impact of future capital gains requires detailed consideration of current and future income projections and resulting tax brackets. The proposed higher capital gains rates do not kick in until income reaches $1 million. If your income fluctuates greatly, it may be possible there are years where your income falls below this threshold.
Tax Mitigation Opportunities in Response To Increased Capital Gains Tax Rate
- Realize capital gains when necessary to fund goals and manage risk.
- Work with your financial advisor to explore asset allocation strategies by placing tax-inefficient assets in tax-deferred or nontaxable accounts. Interest income, dividend income and realized capital gains are not taxed in IRA’s, as such high yield and high dividend strategies along with active strategies incorporating high turnover could be in tax-deferred accounts.
- As a means of regulating annual income levels, use installment sales. Keep them below $1 million as much as possible.
- Consider donating highly appreciated securities to a charity or donor advised fund to avoid capital gains tax entirely.
- Use tax loss harvesting to offset gains.
- Defer tax on capital gains with a charitable remainder trust (CRT). Charitably inclined clients can defer capital gains by creating a CRT. By donating gain property to the CRT before it is sold, the donor will be taxed on the capital gain only as it is remitted back to the donor over the term of the CRT. A charitable deduction for the remainder interest payable to the charity may be available to the donor in the year the CRT is established.
Proposed Cap on Itemized Deductions
Current Tax Law: No cap on itemized deductions; Pease limitations suspended through 2025; cap on State and Local Tax (SALT) deduction.
Proposed Policy Change: Cap itemized deductions at 28% and reinstate Pease limitations for income greater than $400,000.
Deferring deductions typically makes sense when they are more valuable to be used against higher tax rates. However, if these limitations go into effect, the result means that taxpayers earning more than $400,000 with rates higher than 28% would face limited itemized deductions.
Tax Mitigation Opportunities to Combat the New Cap on Itemized Deductions
- Determine if it makes sense to accelerate charitable gifts in 2021 before any constraints on contributions take effect.
- Consider deduction of up to 100% of adjusted gross income (AGI) for cash gifts to public charities under the CARES Act.
- Bunching charitable gifts.
Current Tax Law: 12.4% on earnings up to $142,800
Proposed Policy Change: Expand 12.4% to earnings above $400,000, thus creating the “donut hole” in the current payroll tax where wages between $142,800 and $400,000 are not taxed.
This change would require 60 votes in Congress to withstand a filibuster, as under the “Byrd Rule” changes impacting social security and cannot be enacted through budget reconciliation, making such change unlikely.
Tax Mitigation Opportunities for the Payroll Tax “Donut Hole”
- Maximize contributions to 401(k)s, IRAs and HSAs to provide flexibility, and avoid triggering the top tax bracket created by the “donut hole.”
Get an Estate Planning Audit To Ensure You’re Prepared for These Changes
Although definitive tax policy changes have not yet been enacted, it is highly likely we will see changes to the tax landscape late in 2021 or early 2022. It is imperative for individuals to contact their advisors now to review their estate plans, tax projections, investment portfolios, retirement accounts and asset mixes to identify opportunities for planning and flexibility in anticipation of significant tax legislation.
If you have questions about the Biden administration’s 2021 proposed tax policy, would like to discuss further or are interested in scheduling an estate planning audit, please reach out to Kevin Lenhard at firstname.lastname@example.org or 216.736.7226, or contact any of our Estate Planning professionals.
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