The changing tax landscape and you

Despite the uncertainties, there are strategies to consider if you expect higher taxes.

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Key takeaways

  • Given the outline of recent tax proposals from the Biden administration, it seems that federal taxes may go up, but most individuals earning less than $450,000 likely won’t end up paying more.
  • Higher corporate taxes are likely, but history suggests this might not necessarily negatively impact US equity returns.
  • If taxpayers are concerned that future federal tax law changes might raise their personal rates, there may be some strategies they can employ now to manage taxes on income, investments, and estate planning.
  • Some strategies include accelerating income, deferring income with strategies like nonqualified stock options, and charitable giving.

Are you wondering what the myriad of tax proposals floating around Washington might mean to you? It’s impossible to know for sure. We are in that white-boarding phase of the legislative process when it’s hard to know exactly what will pass and when it will be effective. But if you are concerned about your personal situation, there are things you may want to consider to reduce the impact.

Here's what's likely:

Corporate taxes could head up.

The American Jobs Plan proposes financing a massive infrastructure initiative with an increase in the federal corporate tax rate from 21% to 28%, among other changes.

Individual tax hikes are generally intended to focus on high earners.

The American Families Plan focuses more on education, child care, and other family support initiatives, and calls for the top federal tax bracket on individual income to go from 37% to 39.6%. This would mainly affect individuals with taxable income of more than $450,000 and couples more than $500,000. The plan would also tax capital gains for those with adjusted gross income of more than $1 million at that top rate. The changes in this plan would result in about $661 billion in additional taxes, according to the Tax Foundation.*

The Biden administration’s annual budget and documentation from the Treasury Department, known as the “Green Book,” provides some additional details and clarifications, but still, these are just proposals and it’s unclear what will actually be adopted by Congress and when changes would be effective.

There are razor-thin margins in both houses of Congress, so it's  likely there will be a lot of moderation of the proposals. Anything that passes will likely go through the budget reconciliation process, which could take months. There may be some elements of all the proposals on the table once Congress negotiates the specifics. Major tax changes historically are effective in the next fiscal year, meaning it would be for 2022 income. But some changes, like for capital gains, could be effective sooner—in fact, Biden’s budget proposed setting the date back into the past already.

Here's how it might look for the groups who would be most affected.

High earners

If an individual makes less than $450,000, they likely won’t face any major changes to their individual taxes and at certain lower levels may even benefit due to some of the proposed credits.

If they make more, they’ll want to pay closer attention to how this year’s tax debate unfolds and watch for where specific brackets may ultimately be set. But the devil’s in the details. Even if the top tax rate rises from 37% to 39.6% as proposed, this may not be too dramatic for taxpayers, as it is simply going back to a rate that was in place just 4 years ago. There may be hope yet for offsetting changes like the restoration of the full deduction for state and local taxes—which some legislators from high-tax states are positioning for, but which was not specifically asked for in Biden’s budget proposal.

If you think you may be subject to higher taxes, there are strategies you can consider to accelerate, defer, or offset some of your income to help reduce the potential tax hit for changes that will be effective after 2021. “People in this situation might want to consider things like charitable giving or deferred compensation plans, if available,” says David Peterson, head of wealth planning at Fidelity. 

For example, an executive who believes increasing marginal rates are imminent might want to consider what to do about their nonqualified stock options that are close to expiration. Depending on their expectations for further appreciation, they may want to accelerate potential option income to 2021 and pay taxes at what may be relatively lower rates. It’s important to recognize, however, that Congress’s ability to set an effective date on tax increases may mean the executive has already missed that opportunity.

Depending on the time to expiration, they may want to manage their tax brackets more carefully and exercise options over a few tax periods. However, if an option grant has more time to expiration, they may decide to try and wait it out and bet on a future subsequent tax decrease.

Investors

Some of the most important tax changes involving individual investors will likely only pertain to those with significant capital gains who have adjusted gross income over $1 million, which is less than 1% of the US population, according to IRS data. Most of the impact to other investors will come indirectly, via impact to the overall economy and stock market returns, if higher corporate rates go through.

“The instinct is to say that higher taxes are bad, but in terms of what it means for markets, what matters is the multiplier effect of fiscal spending and Federal Reserve actions. You have to look at the negative and positive in totality,” says Jurrien Timmer, director of global macro at Fidelity. “In the current situation, if you weigh spending and growth, the net for the economy is positive.”

If you have capital gains, there are tax-savvy strategies that can help reduce the taxes that high-net-worth individuals typically already employ with the help of financial professionals. Among them: asset location strategies like placing tax-inefficient assets in tax-deferred or tax-advantaged accounts. Such individuals may also want to consider Roth conversions, to pay taxes now on the conversion amount so that any subsequent growth will be tax-free later.

There are also some one-time circumstances that push people over the thresholds temporarily, like the sale of a business or a highly appreciated property. If you are a small-business owner on the brink of retirement, you might face both at once and you’d want to look carefully at the timing of those transactions with a financial professional.

“It’s important to do planning and modeling. You have to think about what your projected income is going forward and consider all the possibilities,” says Brad Sprong, a partner at KPMG, a financial services firm.

For instance, consider the following hypothetical. An individual is currently thinking of selling a business that would generate $35 million of long-term capital gain with a zero-cost basis. At today’s federal capital gain tax rate of 20% and a Net Investment Income Tax (NIIT) of 3.8%, they could expect their federal taxes on this transaction would be $8.33 million. If the federal rate on capital gains increases to 39.6% under the terms proposed in the American Families Plan, they would pay about $6.7 million more, or approximately $15 million in total.

“They might want to time the transaction to when rates are more favorable, or they might want to consider an installment sale to defer some of the gain if they are eligible and able to negotiate with the buyer,” says Peterson.

Givers

While Biden’s American Families Plan proposes to eliminate the step-up in cost basis at death for gains in excess of $1 million per person ($2 million per couple), the budget proposes changes to lifetime giving as well, with the same exclusions applying.

For example, today, if a person gifts securities with a fair market value of $2 million and a cost basis of $100,000 to a relative, that relative would receive the carryover basis of $100,000. The giver may or may not owe gift tax depending on whether they have any lifetime exemption remaining, but they would not owe capital gains tax. Under the proposed change, the giver would incur a realization event on the gift and owe capital gains tax on the excess over the $1 million per-person exclusion. In this case, it would amount to a tax liability of over $350,000.

“Taxpayers in this kind of situation will want to be sure to have enough cash on hand to pay the bill—liquidity issues will become more important for folks,” says Sprong.

There are still more Congressional proposals on the table, but in recent years, most suggestions to hike these taxes quickly withered on the vine. “Since specific details are lacking in the proposals, it is challenging to get too detailed on strategies,” says Peterson. “So taxpayers should be comfortable with anything they decide to do, such as forever parting with their assets by way of gift, regardless of the tax impact.”

Consider another hypothetical example of someone who is considering the sale of their primary residence, where their realized gain would be $1.4 million. As a single filer, they would only be able to exclude $250,000 of the gain from taxes, which would mean currently they’d have a rate of 20% plus NIIT of 3.8% and owe about $227,000. If the rate increased to 39.6% under the American Families Plan, they’d owe almost $30,000 more. (Note: If they were married, the exemption would be $500,000 and that would keep the gain under the proposed $1 million threshold for capital gains, and the resulting gain, assuming no other realized gain, would not be subject to the 39.6% rate.)

What could they do to reduce the prospect of a higher tax burden in the future?

Donating highly appreciated securities to charity could avoid capital gains tax entirely, in addition to (in many cases) creating a tax deduction. They could also make cash gifts to charity to take advantage of 2021’s deduction of up to 100% of AGI under the CARES Act.

As noted above, Biden's American Family Plan proposed the elimination of the step-up in cost basis at death for gains of more than $1 million, a change which, if adopted, would have significant impact. Investors may want to work with financial professionals to analyze the risk associated with continuing to hold low-basis assets in a rising tax environment, and if proposals become law, may want to consider prioritizing philanthropic giving. When gifting to flexible trust structures to remove potential future asset appreciation from their taxable estates, investors will likely want to gift higher basis assets.

It is extremely important to review your individual financial situation, tolerance for complexity and uncertainty (e.g., if the IRS challenges a transaction), and it’s a good idea to work with an attorney familiar with how to structure and execute these types of strategies.

Timing may well be critical with these decisions. We know based on prior years (particularly in 2012 and 2020), the closer we get to potential legislation and/or year end, the busier attorneys, accountants, financial professionals, and operations teams get.

“The eventual outcome of any changes to income, gift, and estate tax laws is uncertain. Given the dynamics in Congress, meaningful changes and compromises on any final legislation may come to fruition, so stay tuned,” says Peterson.

Next steps to consider



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