In today's episode Nicholas Olesen, CFP®, CPWA® shares key takeaways and insights from the most recent tax change proposal, the Treasury Department’s “Green Book”.
As expected for anyone paying attention to tax policy this year, there are a lot of changes coming in the near future regarding taxes, rates, and estate planning and the Administration just gave a fairly detailed glimpse of what it could look like. A few of the key takeaways covered are:
- Many changes are coming for those with taxable income over $400,000
- The common 1031 exchange could be repealed, greatly impacting those with investment real estate properties
- Long-term capital gains rates could double and the new rates could already be in effect
- S Corporations and Partnerships could lose a valuable tax advantage
- No longer a step-up in basis for assets at death
- Gift and death could now be treated as a realization event, causing income to recipient
You can find a transcript of today’s show below.
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Transcript from today’s show:
for tuning in A Wealth of Advice, my name is Nicholas Olesen, Director of Private Wealth at Kathmere Capital. As expected for anyone paying attention to tax policy this year, there are a lot of changes coming in the near future regarding taxes, rates, and estate planning and we just got a fairly detailed glimpse of what it could look like as the Biden administration released its revenue-raising proposals in the Treasury Department’s General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, or what’s more commonly referred to as the “Green Book.” On today’s show I am going to go over the key takeaways and actionable advice you may want to consider so you don’t have to read through all 114-pages of the proposal.
Let’s dive in and start with taxes for individuals.
For those earning more than $452,700 or $509,300 for joint filers in a calendar year, the proposal is to increase the top marginal income tax rate from its current level of 37 percent to 39.6 percent. For those with qualified business income, which is the Section 199A pass-through deduction, surprisingly it is not proposed to be changed, but we expect it to be repealed or carved back by Congress for taxpayers with adjusted gross income in excess of $400,000.
I expected to see something on the $10,000 cap on state and local tax (SALT) deductions in this proposal, but it was not addressed at all. This is most likely due to all the different opinions in the Democratic party but I still expect it may be repealed and replaced by Congress with limitations on itemized deductions for taxpayers earning in excess of $400,000.
Profits from carried interest are further targeted for taxation at ordinary income tax rates by a Biden administration proposal to eliminate the application of Section 1061 for taxpayers with taxable income in excess of $400,000 and to taxing as ordinary income those partners’ share of income from an “investment services partnership interest” in an investment partnership to which they provide services. Such income also would be subject to self-employment taxes.
Another surprising inclusion was the like-kind exchange rule, which is proposed to be repealed for gains during a taxable year greater than $500,000 ($1 million for joint filers).Now onto one of the most impactful changes for individual investors, an increase in capital gains and dividend tax rates. The proposal it to increase these rates from the current level of 23.8 percent (a 20 percent tax rate plus the 3.8 percent tax on net investment income) to 40.8 percent (a 37 percent capital gains rate plus the 3.8 percent tax on net investment income). The higher rates are proposed to apply “to the extent that the taxpayer’s income exceeds $1 million ($500,000 for married filing separately).” This change in rates removes the current advantage of holding an investment for longer than 1-year in order to save roughly 50% of the tax. The other piece of this that is surprising is that capital gains tax increase apply to “gains required to be recognized after the date of announcement [presumably late April 2021].” Now, based on history, we expect those effective dates may slip and ultimately may apply to sales occurring on or after the date of enactment of the legislation, not the original announcement in April of this year. I do anticipate a single, substantial tax reform package to be enacted sometime in the last calendar quarter of 2021, which could include all or parts of what I am covering today.
Another change that we have anticipated and now see included is to begin taxing all individuals whose income is over $400,000 with the 3.8% Medicare tax, even if their income is from any trade or business that is not otherwise subject to employment taxes. This directly goes after partnership income and S Corporation income, which is currently excluded from Medicare Tax.
Now let’s talk about estate planning and gifting changes in the proposal. Most surprising here is what wasn’t there that many had expected, a reduction in estate and gift tax exemption. However, it’s proposing to make death, lifetime giving and exceeding maximum holding periods for assets in trust recognition events for income tax purposes. If this proposal comes to fruition, gifts and bequests would be subject to not just one tax regime but two, which would have a dramatic impact on estate planning for many individuals. The resulting income tax would be in addition to the potential gift, estate and generation skipping transfer (GST) taxes that may be imposed. This proposal is alarming to many, as it is essentially eliminating step-up in tax basis under Internal Revenue Code Section 1014 for assets included in a decedent’s gross estate. There were certain exceptions to this general rule, such as a $100,000 per person exclusion from capital gains as well as a $250,000 exclusion per person for the gain recognized on the transfer of a principal residence. Further, spouses that received property would have the basis of the donor spouse carried over, and transfers to charity would be exempt from the tax.
The text of the legislation that was released basically would treat gifts and death as recognition events. In addition to the exclusion of $100,000 for lifetime gifts, most importantly for those looking at this for estate planning, a more generous $1 million exclusion for transfers at death. The legislation also introduced some interesting caveats, like the introduction of a deemed recognition event every 21 years for assets held in nongrantor trusts. Another was burdensome reporting requirements that would require all trusts with more than $1 million of assets or $20,000 of income to provide not only a balance sheet and income statement, but also “a full and complete accounting of all trust activities and operations for the year.” Most concerning is that the legislation for this particular section would be retroactive to Jan. 1, 2021, which you will hear is proposed in some other areas of change as well but not in others, so be mindful of that. This is incredible frustrating for those of us that have been trying to help clients through this year get their, quote, ducks in a row for possible change.
The proposal does include a number of exclusions to these recognition events and or the step up in basis. A few of the exclusions include
- Tangible personal property (other than collectibles) isn’t treated as being sold when transferred into or out of a trust or partnership.
- As mentioned before, this proposal provides a $1 million per-person exclusion from gain. This amount is portable to a surviving spouse using the same rules for portability of the gift and estate tax purposes and would be indexed for inflation.
- In addition to general exclusion, the proposal would allow for the exclusion of up to $250,000 of gain per taxpayer on the sale of a principal residence that’s currently allowed under IRC Section 121. We didn’t expect this to be reduced or removed but it was good to see confirmation of that. This $250,000 would also be portable to the surviving spouse for transfers at death.
- Qualified small business stock (QSBS) was included and confirms that the exclusion currently available on QSBS would also apply.
- With respect to transfers at death, losses are available to offset gain under this proposal.
- As is currently the law, under the proposal, transfers at death to a “U.S. spouse” wouldn’t be a recognition event and the decedent’s tax basis would carry over to the surviving spouse.
- Similarly, transfers from decedents to charity are excluded from the estate or income value. However, the proposal applies gain recognition on a proportionate basis for split-interest charitable trusts (that is, lead and remainder trusts) but does not addresses the scenario in which the grantor (or a U.S. spouse) retains the other interest, as is often the case with a charitable remainder trust.
- An interesting modification found in this proposal compared to previous ones is what the basis in the property is for transfers subject to a recognition event. Presumably, if there’s a recognition event then the donee’s basis should be the fair market value (FMV) at the time of recognition. That’s the case for transfers at death and the recipient of the property receives an adjusted basis even if no tax was ultimately owed because of the $1 million exemption. However, for lifetime gifts, the Biden proposal doesn’t provide a basis adjustment for property shielded from recognition by the $1 million exclusion and the donor’s basis will carry over.
- A huge positive for any family-owned and operated business is the proposal allows for an indefinite deferral for family-owned and operated businesses that will be due only when it’s no longer family-owned and operated. This was included along with allowing for a 15-year payment plan on the tax liability for all non-liquid assets and allows more assets to qualify for this deferral when compared with the current estate tax deferral method under IRC Section 6166 that applies only to closely held businesses.
- An strange change was included on valuation whereas the FMV for recognition purposes will be the same value used for estate and gift tax purposes, “a transferred partial interest would be its proportional share of the fair market value of the entire property.” In other words, there won‘t be an opportunity to apply appropriate valuation discounts when transferring minority interests, potentially creating a disconnect for gift and estate and income tax purposes. I’m not sure if this was intentional or an oversight and I’m sure will be addressed in any final language if put into law.
- The Biden proposal is calling for these gain recognition provisions to apply for all gifts and deaths occurring in 2022 or later.
For a select group of individuals that have benefited from the use of intentionally defective grantor trusts (IDGTs), there are some potentially big changes coming. This unique estate planning strategy gives a large benefit in that the property that’s outside the taxpayer’s gross estate can grow income tax free during the grantor’s life as the grantor pays the income tax liability on the trust’s earnings. That benefit remains unchanged by the Biden Green Book. However, the flexibility of IDGTs stemming from the treatment of transactions between the grantor as nonrecognition events because the grantor and trust are considered the same for income tax purposes as set out in Revenue Ruling 85-13 will be impacted. President Biden’s proposal captures these transfers as recognition events, which could reduce the usefulness of these trusts for some families.
Another change to trusts comes for those with “dynasty trusts.” A dynasty trust is one that is Generation-Skipping Transfer tax exempt and has a long or indefinite perpetuities period. Neither state law nor the bite of transfer taxes will bring these trusts to an end. While this proposal doesn’t attack the Generation-Skipping Transfer tax exempt status of a trust, like some other proposal from some Democratic leaders, but instead provides for an income recognition event, stating “[g]ain on unrealized appreciation also would be recognized by a trust… that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years…”. President Biden’s proposal would start counting 90 years from Jan. 1, 1940, meaning that a trust that was in existence in 1940 or earlier that has property not subject to a recognition event will have it recognized no later than Dec. 31, 2030 (90 years after Jan. 1, 1940). For trusts with assets that are regularly sold, this proposal won’t cause much of a tax issue. However, for trusts that hold real estate or closely held businesses, this could create a substantial liability that could prevent the wealth being passed down largely intact through multiple generations.
This latest proposal continues to bring more and more importance to the relationship between income, investments, and estate planning. I hope you found this overview both insightful and informative. Please reach out with any questions you have or if there is any help myself or my team can provide. Take care.