As KJK has been reporting, Congress is gearing up to revise tax laws to target the wealthy and proposed changes could be adopted as early as mid-November. The Senate’s 50 non-Republican members, including 48 registered Democrats and two Independents who caucus with Democrats, are seeking to advance tax reform through the budget reconciliation process, which can thwart the need for bipartisan support by requiring only a simple majority to pass. In the event of a tie, Vice President Kamala Harris would then cast the tie-breaking vote, increasing the chances that a tax change is coming in one form or another.
CURRENT TAX CODE VS. PROPOSED LEGISLATION
Many of the taxpayer friendly provisions currently in the tax code were implemented in 2017 through the Tax Cuts and Jobs Act (TCJA), which was also passed through the budget reconciliation processes under Republican control. The TCJA resulted in a reduction over prior years in both corporate and individual tax rates. By contrast, the proposed legislation released September 13th by the House Ways and Means Committee would impose significantly higher tax rates on both corporations and wealthier taxpayers. With the current makeup of the Senate, tax changes are almost certain to be enacted by this Congress, regardless of what those changes may look like in final form. This article addresses the potential changes outlined in the release of proposed legislation by the House Ways and Means Committee this past September.
IMPLICATIONS OF PROPOSED TAX CHANGES FOR BUSINESSES
Of particular note in this proposed legislation, owners of pass-through entities may see tax increases of anywhere from 9% to 20% for federal income taxes. Profits from businesses will be subjected to the 3.8% net investment tax currently only applicable to dividends, capital gains, interest, rents, royalties, non-qualified annuities and income from instrument trading, among other passive income sources. The legislation would also permanently disallow the business loss deduction for losses in excess of $500,000 (with minor exceptions). The qualified small business stock (QSBS) exclusion will also be limited to 50% for taxpayers with income above $400,000. The corporate income tax rate structure is also set to change, with an increase in the top rate to 26.5% from 21%.
IMPLICATIONS OF PROPOSED TAX CHANGES FOR INDIVIDUALS
The proposed legislation includes an increase in the top ordinary income taxation rate from 37% to 39.6%, which could go into effect as early as Jan. 1, 2022. Long-term capital gains are set to increase from a 20% tax rate to 25%. The higher tax rate for long-term capital gains is proposed to be retroactively effective for all gains realized post-Sept. 13, 2021. For high-income individuals, an additional 3% surtax on taxable income in excess of $5,000,000 is expected for each individual, potentially including both high-earning members of a married-filing-jointly household. Digital assets (including cryptocurrencies), commodities and foreign currency are poised to be included in the expansion of the “wash-sale” rules which suspend losses when taxpayers purchase a “substantially identical” asset within 30 days of the loss taken. Traditional and Roth IRAs in excess of $10 million may be foreclosed from additional contributions, and required minimum distributions (RMDs) of both IRA forms may also increase. Additionally, the legislation prohibits IRAs from investing in assets only available to accredited investors, including many alternative investment funds.
Gift and estate taxes are also within the purview of this legislation. The gift and estate tax exclusion amount will reduce from $10 million (adjusted for inflation) to $5 million effective Jan. 1, 2022. Under current law, that reduction to the lifetime exclusion is not set to occur until Jan. 1, 2026. If a taxpayer transfers assets to in an irrevocable grantor trust, those assets are now proposed to be included in a decedent’s estate, thus effectively eliminating the use of irrevocable grantor trusts as planning tools. Further, additional contributions to an existing irrevocable grantor trust may result in assets being included in a taxpayer’s estate due to the potential that any contributions to the trust after enactment may taint an otherwise “grandfathered” trust and thus severely reduce its tax-effectiveness. The changes to the grantor trust rules are proposed to become effective upon date of enactment of the law.
The legislation also proposes to eliminate valuation adjustments (discounts) for non-business assets. Elimination of valuation adjustments will severely handcuff taxpayers seeking to freeze their estates by transferring or gifting assets to vehicles (e.g., irrevocable grantor trusts, family limited partnerships) that historically incorporate a valuation discount as part of the estate planning process. The elimination of valuation discounts is proposed to be effective upon enactment of the legislation.
ACTIONS TO TAKE NOW TO PROTECT YOURSELF AND YOUR BUSINESS
It is important to keep in mind that it is unclear whether the proposed legislation, in its current form, will be enacted by this session of Congress. First and foremost, now more than ever, it is crucial to engage with skilled tax and estate planning attorneys now to review your individual situation and identify planning opportunities available to you to minimize the adverse tax effects of the proposed legislation. Action steps to consider include:
- Establish and fund irrevocable grantor trusts up to the maximum amount you can give away during lifetime without incurring gift tax ($11.7M for individuals; $23.4M for married couples) before date of enactment (as soon as possible)
- Transfer assets that may be subjected to discounted value before date of enactment
- Fund Grantor Retained Annuity Trusts (GRATs) before date of enactment and consider a longer term than is customary
- Accelerate income into 2021 before tax rates increase in 2022. Consider a Roth conversion for retirement accounts
- Defer deductions (including charitable deductions) to 2022
- Review tax status of operating businesses. Compare “flow through” entities (e.g., LLC, partnership or Sub S corporations) to C corporation status under the current and proposed law changes to identify the most tax efficient classification for your business
If you have questions or would like to discuss further, please reach out to Kevin Lenhard at kjl@kjk.com or 216.736.7226.