8-Sep-21
Tax Man Cometh?
Take-Away: We expect the House’s Ways and Means Committee to release its tax law proposals sometime next week. While most taxpayers are looking for a potential increase in the long-term capital gains tax rate, there may be other tax increases in the proposed bill in Congress’ endless search for revenues.
Background: Earlier this year the House passed a $3.5 trillion bill, often referred to as the Administration’s ‘social policy bill.’ If that bill became law, there would be billions in government revenues devoted to: (i) increasing family and medical leave for all Americans; (ii) expand Medicare to include dental, vision, and hearing benefits; (iii) extend the child tax credit; and (iv) address climate change.
Retroactive Effective Date?: To pay for these benefits Congress needs to raise revenues. That means raising taxes. As mentioned yesterday, the House Ways and Means Committee plans to release next week its proposal to raise revenues to pay for the social policy bill, and it is possible that the bill, if passed, would have an effective date retroactive to the date the bill was introduced, i.e. next week. While the effective date of any legislation is uncertain, and Congress is probably unlikely to make all of the tax law changes retroactive, it is something that needs to be closely watched when the debate on the bill begins in earnest.
Talked About Tax Law Changes: Earlier this year the Administration’s ‘Green Book’ identified several tax law changes that should be implemented as part of the nation’s 2022 fiscal budget. Those taxpayers whose income is less than $400,000 a year, small businesses, and family farms would, arguably, not pay higher taxes. Yet some of the following proposals could affect taxpayers even if their reported income is less than $400,000 a year. Some of those proposals that might well be included in the Ways and Means bill:
Highest Income Tax Bracket: The top marginal income tax bracket would be increased from 37% to 39.6%. If that is the case, then individuals should consider, if possible, accelerating their income into 2021 and/or pursue Roth conversions.
Increase in Capital Gain Rate: While the Administration’s proposal was to effectively double the long-term capital gain rate, and qualified dividends, from 20% to 39.6%, most commentators expect a proposed increase from 20% to either 25% or 30% capital gain rate. If that is the case, then individuals should consider selling appreciated assets if they were contemplating a liquidity event anyway. If those funds are not needed in the short-term, e.g. 1 to 10 years, they might consider holding off selling their appreciated assets. Alternatively, if a near-term sale is contemplated, the individual should consider using an installment sale, thus deferring the recognition of capital gains; if the rate increase occurs, but it is not retroactive to the date the bill was enacted, the the seller can opt out of the installment sale contract and take the gains in 2021.
Limitation on Income Tax Deductions: Some commentators belief this proposal to limit income tax deductions is most likely to occur. The proposal would be to place a limit on the amount that can be claims as an income tax deduction for contributions to charity or to IRAs or 401(k) accounts. Deductions from income would be permitted only up to the 26% or 28% marginal income tax brackets, so that a taxpayer at the 37% income tax bracket would be denied some of his/her deductions to charity or their retirement account. If that is the case, then an individual should max out their retirement plan contributions in 2021 and try to ‘bunch’ their charitable gifts in 2021, e.g. a large gift to a donor advised fund.
Carried Interest as Ordinary Income: This proposal has bipartisan support (if there is such a thing in Washington these days!) Carried Interest (think hedge fund sponsors) would be taxed as ordinary income, not capital gains. If that is the case, then those individuals who hold carried interests should accelerated their carried interest payouts, if that is possible.
Deemed Disposition on Transfers: This proposal has gotten the most attention over the past several months, where the transfer of an appreciated asset, e.g. a lifetime gift, or a bequest on death, would be treated as a sale by the transferor, resulting in the payment of capital gains taxes. If it becomes law, the bill effectively eliminates the step-up in basis on death rule that currently exists. The bill would exclude $1.0 million of transfers from the deemed disposition rule, and another $500,000 on the transfer of the transferor’s principal residence. If that is the case, then there might be a shift to grantor trusts where the transferor retains the right to ‘swap’ assets of equivalent value.
Reduce Applicable Exemption Amount: This proposal would accelerate the scheduled ‘sunset’ of the $11.7 applicable exclusion amount from 2026 to 2022. That would drop an individual’s applicable exemption amount from $11.7 million to $5.0 adjusted to cost-of-living (probably closer to $6.0 million per person.) While some proposals have been floated to reduce the exemption amount to $3.5 million, most commentators believe that is unlikely to occur. If that is the case, then an individual should make lifetime gifts to their heirs now, or to trusts for their heirs.
GRATs and Valuation Discounts: This proposal would require a minimum term for a grantor retained annuity trust (GRAT) of 10 years, which would dramatically curtail the use of a GRAT to shift wealth gift tax-free. Similarly, the proposal would limit the use of valuation discounts when family businesses are transferred. Commentators believe that it is more likely that that the curtailed use of GRATs and valuation discounts will be in future legislation, or if included in this bill, would not be fully implemented until Regulations are published, which will not be retroactive. If that is the case, creating a GRAT in 2021 so that it would be ‘grandfathered’ makes sense. In addition, the transfer of family business interests in 2021 subject to valuation discounts, should also be considered.
A Tax Break?: One positive in the anticipated bill is to lift the $10,000 limit on SALT (state and local taxes) deductions for income tax reporting purposes.
Planning for the Uber Wealthy: One planning strategy for the very wealthy, apparently not (yet) addressed in the proposed House bill, is the investment in private placement life insurance. A private placement life insurance policy is one (I’m greatly simplifying this summary) is not a conventional life insurance policy issued by a life insurance company using its standard insurance products. Rather it is a policy tailored to the needs and goals of the wealthy insured.
The life insurance policy is often placed with an offshore insurer- it is a cottage industry in some of the financial havens like the Cook Islands, the Caymans, Bahamas, etc. The insured transfers millions to the company as a policy premium, in exchange for the life insurance policy.
The key to this strategy is that the earnings generated by the investment portfolio, think of it as the policy’s cash surrender value which increases over time, are dividends, which are not currently subject to income tax as life insurance dividends which are reinvested in the policy. If the policy insured needs cash, the insured then borrows from the policy cash surrender value, again not a taxable event for the insured-borrower. If the policy is held until the insured’s death, the policy’s death benefit is paid out income tax-free. If the policy is owned by the insured until the insured’s death, then the death benefit will be included in the insured’s taxable estate, but since the death benefit can be paid with the appreciated portfolio securities, the gain in those securities will avoid any deemed disposition capital gain tax on the policy owner’s death.
Conclusion: With this Congress, anything is possible. Yet we have something of a blueprint from prior proposed bills and Administration proposals to have a pretty good guess what the initial bill will contain in the way of revenue generation. How many of those proposals actually become law is another matter. That said, some individuals may not want to sit on the fence waiting to see what Congress comes up with in compromise legislation.