A Doubled Capital Gains Tax Rate?

Take-Away: It is possible that a second reconciliation Bill could lead to a doubled capital gain tax for wealthy individuals, should Congress fail to embrace President Biden’s proposed increase in the corporate income tax rate from 21% to 28%. If that becomes a realistic outcome, then individuals who earn more than $1.0 million in income annual should accelerate the timelines for pending transactions including their appreciated capital assets.

Background: Last week President Biden dropped a bombshell when he announced a proposed almost doubling of the current capital gains rate for high earners, going from 20% to 39.6%, i.e. taxing capital gains as ordinary income under the President’s proposal to raise tax revenues to pay for his “Build Back Better” infrastructure proposed legislation. High earners, those with annual incomes in excess of $1.0 million, represent only about 0.32% of U.S. taxpayers. [Actually, with the Medicare surtax of 3.8%, more likely the rate imposed on capital gains would go from 20% to 43.4%.]

Example: Jack owns appreciated real estate which he has fully depreciated over the years. The real estate is now worth $10 million. If Jack sold the real estate today, he would pay a 20% federal capital gains tax (ignoring for simplicity any state income taxes or the Medicare surtax.) That means that if Jack sold the real estate for $10 million and he paid the capital gains taxes, he would ‘net’ $8.0 million. If, instead, Jack waits until later in 2021 to sell the real estate, after the capital gains tax has increased to 39.6%, Jack would have to ask a price of $13.2 million if his goal was to net the same amount from the sale. If Jack decided to hold onto the real estate after the capital gain rate increased to 39.6%,  and he waited five years to sell the real estate, the real estate would have to grow at the rate of 6% annually for Jack to net the same $8.0 million when the real estate was finally sold.

Reconciliation Bills: It is not readily apparent if the President’s surprise announcement was tied to the Senate parliamentarian’s conclusion earlier this month that a second budget reconciliation Bill could be passed by the Senate before September 30,2021. A reconciliation Bill, which is limited to budget and revenue generation, requires only 50 votes in the Senate. There has already been one reconciliation Bill passed this year associated with the $1.9 trillion in revenues associated with the COVID-19 legislation.  If the President’s proposal is not a reconciliation Bill, the Senate would require 60 votes to adopt the legislation, which is probably too large a hurdle for Democrats to overcome.

October or June? The next ‘scheduled’ reconciliation Bill would normally be filed either on or after October 1, 2021, when next year’s fiscal budget is before the Senate. Consequently, while most advisors thought that any new tax legislation would only be adopted sometime in the fourth quarter of 2021, now with the parliamentarian’s decision, it may be that revenue generating Bills to increase revenues might be introduced as early as June 2021.

Revenue Shortfall: Complicating matters is that not all 50 Democratic Senators, e.g. Joe Manchin of West Virginia, do not support the President’s proposed increase of the corporate income tax  rate going from 21% to 28%, which the President indicates would finance his proposed massive infrastructure legislation. Such a raise in corporate income tax rates would generate an estimated $740 billion in revenues over the next 10 years. If the corporate rate was only increased to 25% [per Senator Manchin and other Senate moderates] the revenue shortfall would be an estimated $300 billion over the next 10 years. Accordingly,  if the revenues needed to finance the infrastructure legislation cannot come from corporate income taxes, then Congress could turn to an increase in the capital gains tax rate. [Note, while Bernie Sander’s proposed “For the 99.5 Percent Act” would generate some revenues with its proposed elimination of many perceived transfer tax loopholes, e.g. eliminate grantor trust tax treatment; lower exemptions for estates and lifetime gifts, even if passed as proposed, it would not come close to generating the missing $300 billion in revenues.]

Estimated Revenues Generated: According to the Tax Policy Center, a doubling of the current capital gains tax rate would raise roughly $370 billion in revenues over the next 10 years, which would address the revenue shortfall if the corporate income tax rate was increased from 21% to only 25%.

Effective Date?: Assuming Congress adopted legislation to effectively double the existing capital gain tax rate, the question then becomes when would that legislation become effective?  While a prospective effective date could be used by Congress, that change in rates would probably create havoc with market volatility across all market classes, jeopardizing an already fragile economy. It is possible that the legislation, if adopted, could be made retroactive to January 1, 2021. While it does not seem particularly fair to make a tax increase retroactively, it was done in the past, e.g. OBRA 1993 was signed on August 10 by President Clinton, with an effective date for all of 1993, so at least there is some precedent for a retroactive tax.

Observations: A few quick planning thoughts come from the above ‘what if it all happens in June…? Scenario:

1. Don’t Wait: Those wealthy individuals who are contemplating the sale of their businesses, appreciated real estate, or highly appreciated concentrated stock positions do not have the luxury to wait until the last calendar quarter of 2021 to ascertain what Congress finally comes up with in the way of income tax reform. Reform may be upon us much sooner than we originally thought possible.
2. Use Tax Reimbursement Clauses: Grantor trusts are at risk under the “For the 99.5 Percent Act.” If a possible ‘sale’ of an appreciated asset to an intentionally defective grantor trust (IDGT) is contemplated, i.e. where the IDGT is ‘seeded’ with a gift equal to 10% of the value of the asset to be sold to it, while that ‘sale’ is not a taxable event (until the 99.5 Percent Act becomes law) the amount to be transferred to the IDGT may need to be scaled back to ensure that the grantor has enough retained assets to meet any additional capital gain tax that might result from the ‘doubling’ of the capital gains tax. The risk of increased capital gains taxes also warrants the use of a discretionary tax reimbursement clause in the grantor trust, where the trustee can reimburse the grantor for any taxes the grantor must pay on the grantor trust’s income.  [Revenue Ruling 2004-64.]
3. Diversify with Charitable Remainder Trusts: The diversification of closely held positions in a single stock will have to be reconsidered in light of the high tax cost of diversification. If the capital gains tax rate increase materializes, capital asset owners in need of diversification may want to consider the use of the charitable remainder trust as a tool to implement an asset diversification strategy, or a charitable gift annuity, where the gain is recognized over the transferor’s lifetime.

Conclusion: Things are really heating up in the tax ‘world.’ The “For the 99.5 Percent Act” attacks the transfer tax system, dramatically reducing applicable exemption amounts and increasing transfer tax rates. The “Sensible Taxation and Equity Act, or  STEP Act,  attacks the basis step-up on death and creates deemed sales (at a 39.6% rate) for lifetime gifts.  Now we have a proposal to double capital gains taxes for 0.32% of Americans. It is going to be an interesting summer, that’s for sure.