The Biden Administration has released its fiscal year (FY) Budget for 2022, outlining an estimated $6 trillion in federal spending. The proposal would significantly expand the size and scope of the federal government, with increased spending paid for by increasing taxes on corporations and wealthy individuals and families. The Administration also released its FY22 Treasury “Green Book” which provides detailed descriptions of legislative tax proposals outlined in the President’s proposed budget. The Green Book provides detailed proposals for changes to federal tax law, including increasing the corporate tax rate to 28% from the current 21%, increasing the top individual tax rate to 39.6%, and increasing funding for the IRS to monitor and enforce tax compliance for taxpayers.
Although publication of the Green Book is only the first shot across the bow in the FY 2022 budget and appropriations process, current Democratic control of the White House and Congress indicates that some of its proposals will likely move forward to enactment.
Interestingly, the Green Book indicates that the proposed increased tax rate on capital gains and dividends will take place retroactively. This is very unusual and highly controversial. Additionally, the Green Book provides guidance on eliminating basis step up for lifetime gifts and transfers upon death. This article will explore both of these proposals.
Retroactive Increase in Capital Gains Tax Rate
Currently, individual taxpayers are taxed at preferential rates on their long-term capital gains and qualified dividends. Under current tax law, the highest rate for long-term capital gains and dividends is 20% (23.8% including the additional net investment income tax). The Green Book proposes to tax long-term capital gains and qualified dividends of individual taxpayers with adjusted gross income of more than $1 million ($500,000 for married filing separately) at ordinary income tax rates, with 37% generally being the highest rate currently. Historically, capital gains have received preferential income tax treatment. The Green Book proposal will certainly cause taxpayers and their advisers to consider options to defer or avoid recognition events and triggering the gain. The proposal also removes the incentive to hold capital assets for at least one year, which may result in earlier disposition of assets.
The Green Book also indicates the proposal would be effective for gain recognized after “the date of announcement”. This is understood to be April 28, 2021, the date when President Biden announced the proposal as part of the American Families Plan.
In effect, the proposed retroactive application is changing the rules in the middle of the game. It is really a kick in the shins to taxpayers. The proposal not only effectively doubles the tax rate on capital gains and qualified dividends but prevents taxpayers from planning their financial affairs and implementing long-held tax minimization strategies. As it stands now, if taxpayers did not take action before April 28, 2021 they are out of luck. However, there are some moderate-minded Democrats who may not be in favor of retroactive application. Fortunately, as with other aspects of the Green Book proposals, the effective date could change during the Budget reconciliation process.
Elimination of Basis Step-Up and Deemed Realization Events for Death Transfers, Gifts and Certain Partnerships and Trusts
In general, taxpayers recognize increases and decreases in the value of their assets only at the time of a realization event, such as a sale of the asset. Currently, inter vivos or lifetime gifts of assets result in carry-over basis to the recipient and assets received upon a transfer at death result in a stepped-up fair market value basis to the heir.
Under the Green Book proposal, the step-up in basis at death is eliminated and treats transfers of appreciated property by gift or on death as realization events. The donor and deceased owner would recognize capital gain at the time of transfer of the asset, as applicable, based on the asset’s fair market value at the time of transfer. For lifetime gift transfers, the amount of the gain realized would be the excess of the asset’s fair market value on the date of the gift over the donor’s basis in that asset. For transfers at death, the amount of gain would be the excess of the asset’s fair market value on the decedent’s date of death over the decedent’s basis in that asset.
A decedent would be allowed to use capital losses and carry-forwards to offset capital gains.
Further, the proposal would require the recognition of unrealized appreciation by partnerships, trusts, and other non-corporate entities that are the owners of property if that property has not been subject to a recognition event in the prior 90 years. According to the Green Book, the look-back period begins Jan. 1, 1940, and as such it appears this aspect of the proposal would not become operational until Dec. 31, 2030. Additional details around this proposal were not addressed in the Green Book.
The proposal would also treat contributions to, or distributions from, partnerships, trusts and other non-corporate entities (other than a grantor trust that is deemed to be wholly owned and revocable by the donor) as recognition events. The description of this proposal in the Green Book should give taxpayers and practitioners alike considerable pause. If taken literally, the proposal would drastically change the principles of partnership taxation that contributions to and distributions by partnerships generally are tax free.
The deemed owner of a revocable grantor trust would recognize gain on the unrealized appreciation in any asset distributed from the trust to any person other than the deemed owner or the deemed owner’s U.S. spouse, other than a distribution made in discharge of an obligation of the deemed owner. All of the unrealized appreciation on assets of such a revocable grantor trust would be realized at the deemed owner’s death or at any other time when the trust becomes irrevocable.
Under the proposals, there would be a $1 million per-person exclusion ($2 million per married couple), indexed for inflation, and portable to the decedent’s surviving spouse, from recognition of unrealized capital gains on property transferred by gift or held at death. Under this exclusion, the recipient’s basis in property received by reason of the decedent’s death would be the property’s fair market value at the decedent’s death. The carryover basis rule would apply to the donor of gifted property to the extent the unrealized gain on that property at the time of the gift was not shielded from being a recognition event by the donor’s $1 million exclusion.
Additionally, exclusions would apply to assets transferred to U.S. spouses and charities. Transfers by a decedent to a U.S. spouse or to charity would receive carry over basis of the decedent. Capital gain would not be recognized until the surviving spouse disposes of the asset or dies, and appreciated property transferred to a tax-exempt charity would not generate a taxable capital gain. The proposal would not recognize any gain on tangible personal property such as personal effects (excluding collectibles) and household furnishings. The $250,000 per-person ($500,000 per couple) exclusion under current law for capital gain on a principal residence would apply to all residences and would be portable to the decedent’s surviving spouse.
Payment of tax would be deferred in the case of certain family-owned and operated businesses (which are not defined in the Green Book) until the interest in the business is sold or the business ceases to be family-owned or operated. These businesses would have a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets such as publicly traded securities and other than businesses for which the deferral election is made. The proposal also gives the IRS the authority to require security at any time when there is a reasonable need for security to continue this deferral.
The proposal would be generally effective for gains on property transferred by gift, and on property owned at death by decedents dying, after Dec. 31, 2021, and on certain property owned by trusts, partnerships and other non-corporate entities on Jan. 1, 2022.
We will continue to monitor the legislative process as it unfolds this summer and provide timely analysis and guidance though articles published on our website. In the meantime, if you have questions or would like to discuss further, reach out to Kevin Lenhard at email@example.com or 216.736.7226, or contact any of our tax professionals.