As of May 2022
In 2021, the Biden administration proposed legislation that could result in changes to how American individuals and companies are taxed. Following the passage of the $1.9 trillion American Rescue Plan Act, a host of widely differing proposals were put forward by the President, various Senators, Committees, and both legislative branches of Congress. Finally, in November 2021, the long-awaited Infrastructure Investment & Jobs Act was signed into law.
One of the most important questions facing Congress and taxpayers alike, is what, if any, tax legislation will be proposed or enacted prior to the midterm elections. Last year, the Build Back Better bill proposed dramatic tax changes; however, that bill has lost momentum. Some provisions of the Build Back Better bill could still be enacted, but the appetite for major tax changes seems to have faded.
Notwithstanding the sometimes-radical shifts in specific tax provisions from one proposal to the next, with a $2.77 trillion 2021 budget deficit, there is a possibility of at least some tax increases by the 2022 midterm elections. These are likely to have the greatest impact on upper-income taxpayers and large corporations. President Biden recently introduced his 2023 fiscal year budget proposal which contains variations of the tax provisions included in the Build Back Better bill. While major tax changes may not be enacted, it is important to keep in mind some of the provisions that are still being debated.
Here's a deeper dive into key areas of President Biden’s 2023 budget proposal, where significant increases could affect individual taxpayers, and an overview of various strategies to mitigate potentially higher taxes.
POSSIBLE STRATEGIES TO MITIGATE TAX INCREASES
So, what should taxpayers do? Plan accordingly. 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 ahead of rumored tax changes only to be regretted later.
There has been some concern over the possibility that any tax increase would be retroactive to the beginning of 2021. However, now that 2022 has arrived, any retroactive changes would probably contain a date in 2022, especially since the President’s budget proposal contains specific effective dates.
With such a large variety of tax-planning strategies, it can be difficult to choose one that is suitable. Experienced counsel is critical for taxpayers in order to select and execute appropriate structures that are effective for tax savings while also working out well for their families. Below is a partial list of some of the planning strategies that may be useful in today’s environment:
1. Consider funding charitable gifts with low basis stock to benefit from an immediate income tax deduction and avoid future tax on capital gains. Regardless of whether we see any tax changes, the use of tax-managed strategies as a way to keep more of what you earn has become increasingly important. The value of these strategies can increase in times of volatility. Thus, year-to-date weakness in equities can create more opportunities to harvest losses and maximize after-tax returns through our tax-managed equity strategies.
Similarly, trustees of trusts where accumulated income and capital gains could be subject to the trust’s compressed income tax rates are encouraged to consult tax counsel and work with their investment managers to explore ways to avoid or limit paying higher income taxes. These may include weighing the advantage of distributing income (possibly including capital gains, if permitted by statute and/or the trust document) to beneficiaries who are in a lower-income tax bracket versus the benefits of retaining the income in the trusts for future growth and creditor protection outside the beneficiaries’ estates. It may be advisable to have new non-grantor irrevocable trusts give the trustee discretion to make distributions of trust income to charity, thereby qualifying the trust for an income tax charitable deduction. Also, trusts with large unrealized gains and accumulated income should consider changing the trust’s income tax situs to reduce or eliminate the state income tax.
2. Utilize remaining gift and estate tax exemption of $12.06 million per person, or $24.12 million per couple, by making gifts outright or in trust to your heirs.
- This is a “use it or lose it” situation which—while currently not affected by the reconciliation bill or the President’s budget proposal—remains important given the sunset of the generous federal estate and gift tax exemption on December 31, 2025, as well as the focus of the current administration on lowering the exemption.
- Note that the IRS confirmed that there is no clawback of any previously used exemption if the exemption is later reduced before death.
- These gifts can have the additional benefit of shifting embedded capital gains to taxpayers who are tax exempt or in lower tax brackets (e.g., charitable gifting of an appreciated asset, substitution of assets in an entity, or gifting to family members or descendants in lower-income tax brackets).
- Careful consideration has to be afforded on whether to gift assets outright or to trusts, as trusts provide greater protection from creditors and tend to preserve wealth within the family.
3. Consider funding various trusts and other structures that benefit from relatively low interest rates and the current historically high gift and estate tax exemption.
- Examples of such trusts include Spousal Lifetime Access Trusts (SLATs), Grantor Retained Annuity Trusts (GRATs), Intentionally Defective Grantor Trusts (IDGTs) and Charitable Lead Trusts (CLTs).
- These trusts are often set up as “grantor trusts” so that the grantor pays the income taxes on the trusts, allowing the trust assets to grow without the burden of federal or state income taxes.
- Caution is imperative. The provision in the President’s budget proposal that imposes a gift tax on income tax paid by the grantor on the grantor trust’s income does not apply to trusts that are created on or before the effective date. However, the provision that creates a recognition event for post-effective date transfers of appreciated assets applies to existing trusts, regardless of when it was created.
4. Manage your tax-deferred retirement accounts now and later on. While the provisions outlined below are not contained in the President’s budget proposal, they are still on Congress’s radar and could be implemented in the future.
- Given the focus on very large balances and the proposed legislation to reduce these for those with income greater than $400,000 single/$450,000 joint, plan for the possibility that you may have to take unanticipated distributions if your total balances exceed $10 million. You may also want to reconsider making contributions that would cause those accounts to exceed, or grow to exceed, $10 million.
- If current or anticipated income is at or above $400,000 single/$450,000 joint, and you intended to convert from a traditional IRA or defined contribution account to a Roth at some point in the future, consider doing so sooner rather than later, before this may no longer be an option for you. This may be particularly important for those who have accumulated significant after-tax balances in their traditional tax-deferred accounts, as these are typically the most tax efficient rollover to a Roth and are in the cross hairs of proposed legislation to be prohibited as soon as next year. However, converting pre-tax contributions in a traditional IRA, or tax-deferred retirement account to a Roth IRA, is a taxable event that generates ordinary income for the owner. Implement a strategy to convert in tranches to limit your income over time or offset a larger income spike from a one-time conversion with a charitable deduction for a gift to a public charity, donor advised fund or private foundation.1
5. Interest rates are still historically low but trending higher given the Federal Reserve (the Fed) has initiated its first rate hikes since 2018 in an effort to combat inflation. Before further possible rate increases, there are a number of planning options involving the use of credit.
- Intrafamily loans can shift future growth to family members in lower tax brackets. Low-interest loans can allow for the transfer of wealth to the borrower without using the lending family member’s gift and estate tax exemption.
- Borrowing against an investment portfolio can avoid the realization of capital gains while tax rates are high. This can be used for current cash needs or to make the aforementioned intrafamily loans.
- Similarly, families that have outstanding promissory notes (whether standalone or as a part of sale transaction) should consider refinancing those to take advantage of the lower rates without gift tax implications.
6. Take advantage of valuation discounts when gifting minority interests and illiquid assets before these are reduced or even eliminated.
Tax planning is a continuous process and an essential part of wealth planning. Although it is uncertain whether we will see tax changes in 2022, clients who are interested in pursuing tax-planning strategies are encouraged to seek advice from their wealth managers and tax professionals to ensure their choices are consistent with their goals and family situations.