Our Widerman Malek team is focused on explaining issues pertaining to tax, bankruptcy, wealth transfer and preservation, as well as trusts and estates in plain language. Today, the focus is on President-elect Biden’s tax proposals and the potential comprehensive changes. Given the possible impacts, we are urging our clients and friends to contact us now. Time may not be on your side.
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act of 2017 (TCJA). Many of the changes brought about by the TCJA, in particular individual income tax changes, expire on December 31, 2025 (a/k/a “sunset”), at which point those changes revert back to the pre-TCJA status. Individual income taxes account for the largest source of revenue for the federal government. President-elect Biden’s plan is to reverse many of these changes, which would require Congressional support. It also is anticipated that if successful in reversing or modifying many, if not all the TCJA changes, the effective date of those changes could be January 1, 2021.1
Income Tax Changes
A number of Biden’s tax proposals target taxpayer’s with income in excess of $400,000.2 Potential changes include:
- The FICA tax currently is bifurcated into two components to fund Social Security and Medicare. The Social Security portion (Old-Age, Survivors and Disability Insurance) is assessed on the first $142,800 for tax year 2021 at 12.4% (6.2% paid by the employer and 6.2% paid by the employee). There is no limit on the amount of earnings subject to the Medicare portion of the FICA tax. Biden’s proposal would impose a 12.4% Old-Age, Survivors and Disability Insurance payroll tax on income above $400,000, shared equally between the employer and employee. For taxpayers subject to “self-employment” tax, you would pay the full 12.4% with presumably a deduction to gross income for the “employer” portion of the tax. As such, if enacted there would be a gap between $142,800 and $400,000 where no payroll tax is assessed. For owner-operators, you should evaluate the ability to elect S Corporation status since, under current law, net earnings from an S Corporation are not subject to “self-employment” tax.3
- The top individual income tax rate for taxable income in excess of $400,000 would increase from its current 37% rate under the TCJA to 39.6%, the top rate in effect before the TCJA.
- Tax long-term capital gains and qualified dividends as ordinary income for income in excess of $1 million. It is unclear if the threshold applies to $1 million of gross income, adjusted gross income or taxable income.
- Effectively eliminate the step-up in basis at death. Under current law, if a taxpayer dies owning appreciated property, then the beneficiary receives that asset with its tax basis equal to fair market value on the date of death, thus potentially permanently escaping taxation. As a former tax professor of mine once stated, “Death is the best income tax planning, but it comes with a high cost.” For example, a parent dies leaving their home to their child. The parent had bought the home for $100,000, and at the date of death, it was worth $500,000. The child could then sell the home for $500,000 – free of any income tax. It is not entirely clear if Biden’s proposal would impose a tax at the time of transfer on the unrealized appreciation or simply repeal the basis step-up. If there is a tax imposed on the unrealized appreciation of capital gain assets, this could be devastating to the small business owner looking to transfer shares or units in a business to the next generation. For example, suppose the business is worth $1 million but the basis in the stock is only $150,000. A parent dies leaving the stock to his/her child(ren). There is an $850,000 gain that could get taxed at death without the cash to pay that tax. This could result in a “fire sale” of the business or another transaction to monetize the asset to pay the tax.
- Replace the current deduction for contributions to a 401(k)/IRA with a credit of 26% for each $1 contributed. The credit is deposited into the retirement account, requiring tax paid now on the contribution as opposed to paying less tax today. Query whether this proposal, if enacted, changes taxpayer behavior among higher-income earners and increases the popularity of Roth IRAs and Roth 401(k).4
- Eliminate the qualified business income tax deduction for pass-through business owners whose income is $400,000 or more.
Historical tax planning was to accelerate deductions and defer income. Given your particular situation, it may be wise to accelerate income and defer deductions.5 Some of the above changes will not require changes to systems, etc.; however, others will. For example, changes regarding the treatment of contributions to a 401(k) would require significant modifications to payroll reporting systems that could delay the effective date of implementation.
Estate Tax & Gift Tax Planning Changes
- The most sweeping proposal would reduce the current estate tax exclusion amount from $11.58 million ($23.16 million for a married couple) to as low as $3.5 million ($7.0 million for a married couple) – the 2009 exemption amount.
- The gift tax exclusion, which is currently equal to the estate tax exclusion, would be reduced to $1 million. This means that any taxable gifts in excess of the $1 million could give rise to a gift tax liability. The law currently allows present interest gifts of up to $15,000 per donee to be exempt.6 People often mistake that this means that they can only gift $15,000 per year. There is no limit on the amount you can gift. The question is whether the gift gives rise to a gift tax liability. Under current law, a single individual (ignoring prior gifts) could gift $11.58 million without paying a gift tax. There is a filing requirement, however, even if no gift tax is due where there are gifts to one donee in excess of $15,000.
- Restore the estate tax and gift tax rates to the 2009 amounts with a top rate of 45%.
- Some practitioners believe there could be a repeal of GRATs (grantor retained annuity trusts). GRATs are a popular estate tax planning tool, particularly beneficial in this low-interest-rate environment. In order to not be included in the grantor’s gross estate, the grantor must outlive the term of the GRAT. The grantor transfers property, usually property with a high propensity to appreciate, to a trust while retaining an annuity for the term of the trust. Any assets remaining at the end of the trust term pass to the remainder beneficiaries. The transfer to the GRAT is generally designed to generate a taxable gift of zero ($-0-) with an annuity payout of as short as two years. With a “zeroed-out” GRAT, no gift tax exemption is used in the transaction, and the grantor receives his or her money back in only two years. Over the past few years, certain Congressional lawmakers have introduced legislation that would reduce the appeal of GRATs. Proposals have included a minimum GRAT term of 10 years. With the need to raise taxes, anything is on the table.
Widerman Malek Takeaway
As of the date of this article, it is still unclear if the Republicans will maintain control of the Senate. If the Democrats gain control of the Senate (or if the Senate is split 50/50, Vice President-elect Harris could be the tie-breaker), the likelihood that Biden could push forth sweeping tax law changes, including retroactive changes, increases significantly. As such, with only 53 days remaining until midnight on December 31, 2020, it would behoove you to take action now and reach out to us to discuss your personal situation and what steps, if any, you can take to minimize the impact of any tax increases.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, investment or accounting advice nor does it create an attorney-client relationship.