Tax Increases Are Coming. Or Are They?

President Biden campaigned on an extensive list of tax changes. But it is unlikely that all these measures will be enacted as proposed, especially during the first year of the new administration.

With a new administration in place, many Americans are concerned about the prospect of higher taxes. Their anxiety is justified ­­–– with a record $3.1 trillion budget deficit and pandemic-related stimulus packages projected to lead to even higher federal debt,there is a strong probability of at least some tax increases ahead. Plans to raise taxes are fueled further by the desire among some influential legislators to reduce income inequality through higher taxes for upper income taxpayers.

In his pre-election campaign, President Joe Biden put forth an extensive list of planned tax increases, some of which were quite extreme. Exhibit 1 outlines some of the key recommendations that may affect individual taxpayers. However, it is unlikely that all these measures will be enacted as proposed, especially during the first year of the new administration. For one, the administration’s immediate focus is on containing the pandemic and bolstering the economy. Further, with a strongly divided country and slim majorities in Congress, dealing with major tax increases is likely to be a long-term project.

Exhibit 1: Potential Tax Changes

This paper explores some of the key tax areas where significant increases would affect individual taxpayers, as well as how and when these increases may become effective. There are a number of strategies available to mitigate potentially higher taxes. These range from relatively straightforward transactions, such as making forgivable loans to heirs, to more complex trust structures that lock in the current transfer tax exemption but impact future access to the funds. Clients who are interested in pursuing these are encouraged to seek advice from their wealth managers and tax professionals to assure their choices are consistent with their personal tax and family situations.

The Path of Least Resistance

Reversing selected provisions of the 2017 Tax Cuts and Jobs Act (TCJA) appears to offer one of the easiest places to start. Bringing the highest marginal income tax rate for individuals with taxable incomes greater than $400,000 back up to 39.6% from the current 37% is a less drastic move than many of the other proposed changes. The 3.8% Medicare surtax on investment income would remain. Reverting to a top total tax rate of 43.4% would affect the more affluent taxpayers and arguably just return rates to the prior status quo.

Similarly, raising the 21% corporate income tax rate does not seem a radical move. Taking it up to the pre-election proposal of 28% is attractive as estimates indicate this would raise an additional $1 trillion in revenue over the next 10 years.2 However, this large an increase may be a nonstarter. A possible first step could be an increase to 25%.

The TCJA also introduced a restriction on the maximum deduction for state and local taxes of individual taxpayers to $10,000. This highly controversial item, known as SALT, could be a popular target for reversal, particularly among Democratic legislators from high-tax states that are facing waves of out-migration. Given that this would benefit upper income taxpayers most, the deduction, if reinstated, may be capped at a lesser rate than the maximum tax bracket.3

Further proposed restrictions on itemized deductions include a 28% cap (probably with an exception for charitable gifts and mortgage interest), and restoring the Pease limitation for taxable incomes greater than $400,000.4 While these have received less media attention, they could be attractive moves given the fact they affect primarily higher income taxpayers.

Capital Gains in the Crosshairs

There has been considerable discussion over ways to capture more tax revenue from capital gains. President Biden’s pre-election proposal advocated increasing the tax rate on both capital gains and qualified dividends from the current 20% (or 23.8% including the Medicare surtax) to a rate equal to that for ordinary income. Such a monumental jump seems unlikely, and in fact could be counterproductive. Studies show that higher capital gains tax rates do not lead to a significant change in economic growth; in fact, higher capital gains tax rates are a disincentive for investors to realize capital gains, resulting in less tax actually collected.5 This fact notwithstanding, given the focus on income inequality, bumping the rate up to the 25-28% range would appear likely, possibly only for those in top tax brackets or those earning over $1 million annually.

Further attacks on capital gains include taxing unrealized capital gains under a “mark-to-market” plan favored by incoming Senate Finance Chair Ron Wyden. This is a major change and could prove administratively challenging, so it is not likely to become law in the immediate future. Another suggestion is the elimination of the step-up in the cost basis of appreciated assets at death. The latter could involve carrying over the cost basis of decedents’ assets to heirs, so the heirs would realize the embedded capital gain when they sell the inherited assets. It could also take the form of the more radical “deemed disposition” tax imposed immediately at death as is done in Canada.6 This, as with Senator Wyden’s proposed tax on unrealized capital gains, seems unlikely in the near term.

Related to the elimination of the step-up in cost basis at death are increases in estate and gift taxes. President Biden’s pre-election proposal called for a reduction of the current $11.7 million per person estate and gift tax exemption to the pre-TCJA level of $3.5 million for estates and $1 million for gifts. Uncoupling the gift tax exemption from the estate tax exemption has not been popular and appears unlikely. However, a reduction in the exemption, possibly to something between the current $11.7 million and the proposed $3.5 million, may be more palatable. Similarly, raising the rate on assets above the exemption (currently 40%) appears less controversial. Also related to increased transfer taxes are restrictions on the valuation discounts available for gifts and inheritances of partial interests and illiquid assets. These have been a target of past administrations, which, although struck down by President Trump’s executive order, remain a priority item.

The attacks on the preferential rate for “carried interest”7 have had bipartisan support. Taxing this as ordinary income rather than long-term capital gains would apply to those earning more than $1 million annually, which appeals to progressives seeking ways to reduce income inequality. This seems a likely near-term item.

Among the myriad additional pre-election proposals are a number of goodies for lower income taxpayers, ranging from increased child credit to benefits for first-time home buyers. One that has particular appeal due to its potential for raising significant revenue is adding the 12.4% Social Security payroll tax for earned income greater than $400,000.8

Retroactivity: The Elephant in the Room

Equally concerning to more affluent taxpayers is the possibility that tax increases will be retroactive to the beginning of 2021. This would mean actions taken now, which under the current tax regime would generate a certain level of tax or possibly no tax, may end up being taxed more heavily by the time 2021 tax returns are due.

While at first blush this appears sneaky and possibly illegal, retroactive tax changes can be done for a “legitimate purpose,” which includes changes in income taxes. In fact, the August 1993 Omnibus Reconciliation Act changed taxes retroactively to January 1993.

However, retroactive increases are highly unpopular and so quite rare. More often, tax increases become effective at a future date. For example, the 3.8% Medicare surtax enacted in 2012 became effective January 1, 2013. So although theoretically possible given the composition of the Senate, changes enacted in 2021 are more likely to be effective in 2022.

Conclusion

So what are taxpayers to do? Now is the time to plan, but not panic. Remember the old but relevant advice not to let the proverbial “tax tail” wag the dog. History is littered with examples of hastily crafted documents and asset transfers done in front of rumored tax changes and later regretted.9

To guard against the possibility of retroactive changes, it could be prudent to wait until later in the year to complete a transfer. However, those who have large taxable estates who intend to leave significant amounts to their heirs may want to consider planning now regarding how and when to do so up to their remaining exemption amounts.

The proposed changes to many areas in the U.S. tax regime are far-reaching and may significantly affect the wallets of upper income taxpayers. The question of if and when they may be enacted and become effective adds a further dimension to planning around them. In doing so, it will be important for clients to consult with their wealth managers and legal and tax advisors who can recommend structures that provide for ongoing –– albeit typically somewhat limited –– access, as well as successful outcomes even with retroactivity.

  • 1. Herzig, Belinda; Nelson, Richard; Crain, Joan, “Tax Increases; Implications on Capital Formation and Growth,” BNY Mellon Wealth Management, January 2021.

    2. Daniel L. Mellor, JD, LLM, “President-Elect Joe Biden’s Tax Reform Proposals,” Kulzer & DiPadova, P.A., January 2021.

    3. For instance, the maximum deduction could be 28% of taxpayers’ income regardless of their marginal bracket.

    4. The Pease limitation imposes a 3% reduction in itemized deductions for every dollar of income over $400,000.

    5. See Herzig et al, page 3.

     6. See Crain, Joan and Miller, Justin T., “Stepping Away from the StepUp in Basis at Death: A Global Perspective,” Leimberg Information Services, Inc., Email Newsletter Archive Message, September 17, 2020.
     
    7. Carried interest is a share of any profits that the general partners receive as compensation regardless of whether they contribute any initial funds. Although clearly compensation, it is currently taxed as long-term capital gains.
     8. The payroll tax on income above $400,000 would raise an estimated additional $820 billion over 10 years. See Mellor.
     9. Tax and legal professionals continue to deal with the aftermath of the December 2012 rush to fund trusts before an anticipated but unrealized reduction in the transfer tax exemption. Grantors and beneficiaries of these irrevocable trusts are now struggling to find ways to amend and unwind trust provisions that are ill suited to their family situations.
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