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George F. Bearup, J.D. Senior Legal Trust Advisor

11-Jan-21

2021 – What Might We Expect in Tax Law Changes

Take-Away: With the Democrats now clearly in control of the federal government, we can expect a lot of discussion, and probably some action, with modifications to the federal income and transfer tax laws. President-elect Biden has promised more income taxes and a lower federal exemptions from transfer taxes. Exactly when they arrive, and in what form, is anyone’s guess.

Background: With the two Senatorial races in Georgia now behind us, it is time to start looking at what a Congress controlled by the Democrats might do with regard to federal taxes. Many legislators have made no secret that they believe the 2017 Tax Act favored the wealthy and corporations more than the middle class, so that Act’s provisions might prove to be short-lived. What follows is admittedly something of a re-hash of early summaries of what tax law changes we might encounter with Mr. Biden’s election and a 50%-50% Senate [controlled by Democrats with Vice-President Harris casting the tie-breaking vote.]

Reduction in the Transfer Tax Exemption Amounts: Under the 2017 Tax Act an individual’s basic exclusion amount, i.e. their transfer tax exemption, is $11.7 million for 2021. [IRC 2010(c)(3.] That exemption covers both lifetime gifts or federal estate taxes at death. There is also a federal generation skipping transfer tax (GST) exemption of $11.7 million.

  • $3.5 Million: While these high exemption amounts are scheduled to sunset beginning on January 1, 2026 [IRC 2010(c)(3)(B)], Mr. Biden has proposes to lower the federal estate and GST tax exemptions to $3.5 million per individual.
  • $1.0 Million: Biden has also proposed to reduce an individual’s federal gift tax exemption for aggregate lifetime taxable gifts from $11.7 million to $1.0 million.

Increase Transfer Tax Rates: The current federal gift, estate and GST tax rate is a flat 40%. [IRC 2001(c).]

  • 45%: Biden has proposed to increase that flat transfer-tax rate to 45%. There has also been some limited discussion (in lieu of imposing Bernie Sander’s ‘wealth’ tax) to increase that rate to 55% for some high-net-worth individuals who transfer wealth either during lifetime or at death.

Increase in Long-Term Capital Gain Tax Rates: The current rate imposed on long-term capital gains is between 0% and 23.8%. [IRC 1(h) and IRC 1411.]

  • Ordinary Income Tax Rate: Biden has proposed that for individuals who report taxable income of more than $1.0 million that their long-term capital gains would be taxed at the maximum income tax bracket for ordinary income, e.g. 37% to 39.6%. In other reports, Mr. Biden proposed capital gains taxed at ordinary income tax rates if their reported income was above $400,000.

Grantor Retained Annuity Trusts (GRATs) Curbed: GRATs are an effective way to shift wealth gift tax-free, particularly in the current low IRC 7520 interest rate environment.[IRC 2702; Regulation 25.2702-3.] If the assets transferred to the GRAT grow in value faster than the IRC 7520 rate that is used to value the grantor’s retained annuity interest in the GRAT, the assets remaining in the GRAT when the grantor’s annuity comes to a close pass to the GRAT’s remainder beneficiaries free from any federal gift tax. GRATs are often ‘zeroed out’ so no taxable gift is made when the GRAT is initially funded with assets. In addition, most GRATs have relatively short annuity payment periods, e.g. two years, to maximize their wealth-shifting feature and to minimize the inclusion of the GRAT’s assets in the deceased grantor’s taxable estate if he/she dies while the annuity obligation is outstanding and not fulfilled at the time of death.

  • Longer Duration, Taxable, GRATs: Biden has proposed to require GRATs: (i) to be at least 10 years in duration, i.e. no more short-term, cascading GRATs; and (ii) to have a minimum remainder interest value of 20% of the value of the assets initially transferred to the GRAT, i.e. no more zeroed-out GRATs so that a taxable gift will occur when the GRAT is funded.

GST Exempt Dynasty Trusts Curtailed: Large amounts are often transferred to irrevocable trusts using the grantor’s Gift and GST exemptions of $11.7 million each, so that multiple generations of  beneficiaries can enjoy the use and income from those $11.7 million (or more) in assets without those future generations incurring a gift, estate, or GST tax. [IRC 2631.]

  • Maximum 90 Year Exemption from GST Tax: Biden has proposed to impose a limit on the effectiveness of the grantor’s allocation of his or her GST tax exemption to 90 years.

Increase the Maximum Income Tax Rate: Under the 2017 Tax Act the maximum ordinary income tax rate was reduced from 39.6% to 37%.

  • Return of the 39.6% Rate: Biden proposes to return the maximum federal income tax bracket to 39.6%. The corporate income tax rate would also be increased from 21% to 28%.

Eliminate Basis Adjustment at Death: The current Tax Code provides an income tax basis adjustment to assets that are included in the decedent’s taxable estate. [IRC 1014.] An income tax basis adjustment, often called a ‘step-up’ in to the income tax basis to the date of death value, is  viewed by many as a trade-off for the exposure to have to pay federal estate taxes.

  • Carry-Over Tax Basis at Death: Biden has proposed for a limited income tax basis adjustment at death. Up to $1.0 million in assets could receive a tax basis ‘step-up’ on the owner’s death, but the balance of the assets included in the decedent’s taxable estate at death would continue with the decedent’s income tax basis. [How that basis would be allocated remains a mystery.] Thus, the incentive to hold appreciated assets until death to gain the income tax basis adjustment would be eliminated.

Dollar Limits on Charitable Income Tax Deductions: Currently charitable gifts are limited to the donor’s adjusted gross income (AGI) for the tax-year, and further limited by either the nature of the asset (e.g. artwork) or the nature of the charitable recipient, (e.g. a private foundation.) Otherwise, the donor, if so inclined,  could make substantial charitable gifts to reduce the donor’s taxable income, or to carry over the unused charitable income tax deduction to use in the following five tax-years. In short, the donor’s federal income tax liability can be heavily ‘managed’ by large charitable donations in a tax-year.

  • No Charitable Deduction Above $400,000: Biden proposes to limit the savings from charitable deductions for those individuals who earn more than $400,000. The donor would only be allowed to deduct charitable gifts from the portion of their income taxed at 28%, rather than the portion of their income taxed at higher income tax rates paid. The net-effect would be to increase the after-tax cost of charitable gifts by those affected by as much as 13% per dollar donated.

Conclusion: One suspects that President Biden and all of Congress will have their hands full for much of 2021 just dealing with controlling the spread of the COVID-19 virus, stabilizing the economy and putting millions back to work. How soon they turn their attention to changes to the tax laws to pay for the billions the government has borrowed to deal with the pandemic remains to be seen.  In the past, some tax law changes have been made retroactive to the first of the calendar year in which the tax was enacted, but those changes deal with ‘tweaks’ to existing taxes. If new taxes were to be imposed, e.g. a wealth tax, which Mr. Biden has so far rejected, in short a ‘new’ tax, then its effective date would normally be prospective in nature. My guess, and it is only a guess, is that Congress will not turn its attention to implementing many of the tax law changes until late in 2021, and more likely 2022. If that holds true, then many individuals should no longer delay in taking advantage of the currently favorable tax laws and they should act now.