Politics aside and from a financial planning standpoint, one of the biggest concerns regarding the recent elections is President Biden’s proposal for significant tax increases, especially for “higher-income earners and wealthy” individuals. While these are theoretical proposals it's always beneficial to look to the future and consider what tax policy changes could take place, how they could affect individuals and their businesses, and what planning opportunities may exist to address them.
The proposed tax changes are wide-ranging and substantial. They include increasing ordinary income and capital gains rates on higher-income earners, significant changes to corporate tax rates along with more restrictive Qualified Business Income Deduction qualifications, sweeping changes to deductions and credits, as well as substantial increases in gift and estate taxes.
A number of these changes apply specifically to taxpayers making more than $400,000 annually, such as being subject to a new maximum tax bracket of 39.5%, even though the threshold for being in the highest tax bracket under the current Trump tax cuts and Obama era tax code were significantly higher. In addition, taxpayers earning over $400,000 could see their Qualified Business Income Deduction (QBI) eradicated. The Trump tax cuts implemented the QBI which allows owners of pass-through entities, such as LLCs, S-corps, partnerships, etc., a 20% deduction on their pass-through income – a significant tax benefit. Business-owners with incomes of at least $400,000 may experience a double tax increase by not only being exposed to a higher tax bracket but by paying the higher tax bracket on 100% of their business income. Along similar lines, the proposed tax plan aims to eliminate 1031 exchanges for high-income earners which currently allows investors to defer capital gains on an investment property by investing the appreciated proceeds of one property into a similar one.
In addition to the QBI changes, another proposed business tax change is an increase in the corporate rate from 21% to 28%, as well as the implementation of a corporate alternative minimum tax based upon book income (the corporation’s profits before being adjusted for taxes). While most private corporations elect S status to become pass-through entities and avoid double taxation, C corporations may continue to have the ability to pay lower tax rates than their owners do personally, albeit not to the extent they are currently.
Another aspect of the plan includes taxing long-term capital gains for incomes exceeding $1m at ordinary income rates as opposed to a maximum rate of 20%, a 19.5% increase. Repealing the step-up in basis at death is also on the table. Currently, heirs inherit assets with a basis equal to the fair market value on the date of death. If enacted, and coupled with the increased capital gains rate above, the tax on inherited appreciated assets could be substantially increased for those with incomes over $1m.
Not the least bit concerning are the proposed changes to the federal estate and gift tax exemptions. Currently, the estate and gift tax exemption is $11.7m per person or $23.4m per married couple. Biden proposes to cut the exemption in half to approximately $5m per person. Clearly, this has significant implications for private business owners where illiquid assets make up a significant portion of their estate. A $20m estate that today has no estate tax liability, could potentially be facing a $4m estate tax in the future (if the 40% estate tax rate stays intact).
If the changes are pushed through in 2021, there will be no planning opportunities with the current tax law. Conversely, should the changes occur post-2021, there may be an opportunity for taxpayers to leverage the current code to their advantage. For those who will be in a higher income tax bracket, there may be tax savings through the timing of income and deductions in 2021. For those that earn over $1m, they may wish to harvest unrealized capital gains in 2021 at lower rates. People with large taxable estates may benefit by accelerating gifts with the current, much higher estate and gift tax exemptions.
These are only proposed changes and there is still much uncertainty regarding what shape the tax law changes will ultimately take. However, given the democratic control in government, changes to the tax code to some extent are likely. Given the host of issues our country is now facing, will it happen in 2021? No one knows. As the proposed tax changes become clearer, in terms of policy and timing, you and your advisors will be in a better position to outline the tax planning opportunities that apply to you.