As of December 10, 2021
The past year has seen a plethora of proposed changes to taxes on American individuals and companies. 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 early November, the long-awaited Infrastructure Investment & Jobs Act was signed into law.
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The proposals continue as the more contentious Build Back Better bill has moved from the House of Representatives to the Senate for further debate, with the goal that proposed spending on social programs and climate change will be passed through the relatively faster reconciliation process.
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 strong probability of at least some tax increases ahead, if not by year end, in 2022. These are likely to have the greatest impact on upper-income taxpayers and large corporations.
The following chart [Exhibit 1] outlines key tax increases as proposed by President Biden in his Build Back Better plan, most of which were retained without change in the reconciliation passed by the House of Representations on November 19. However, there are several key steps before these become law. The most immediate and critical appears to be the Senate’s review. Policy differences, compounded by concerns of inflationary outcomes, have caused rifts within the Democratic party as well as interparty disagreement. Due to uncertainty surrounding if these latest items will be enacted immediately, or even at all, and the possibility that alternative targets may surface in yet another radical shift, we have created a list of proposed tax increases from prior plans that don’t appear in the current Build Back Better bill [Exhibit 2].
Total estimated cost of the proposed social safety net provisions: $1.75 trillion. Total estimated cost of the revenue offsets: $1.995 trillion. The plan is more than fully paid for as a result of the revenue raising provisions outlined above.
Here's a deeper dive into some of the current tax areas where significant increases would affect individual taxpayers, and an overview of various strategies to mitigate potentially higher taxes.
SALT Deduction: Reversing or modifying the provision of the 2017 Tax Cuts and Jobs Act (TCJA) that limited the federal income tax deduction for individuals’ state and local taxes (SALT) to a maximum of $10,000/year is proving to be one of the most controversial but probable provisions to make its way into final legislation.
Reversing this highly controversial item is particularly important to Democratic legislators from high-tax states that are facing waves of out-migration. However, given that this would benefit upper-income taxpayers most, the deduction may be limited to taxpayers with incomes under the top bracket, and/or capped at a lesser rate than the maximum tax bracket. The latest version of the Build Back Better Act raises the cap to $80,000 for all taxpayers, which is proving a major sticking point in Senate debates.
Surcharge on income for top earners: Under the reconciliation bill, households and trusts with incomes exceeding $10 million (joint and individual), or $5 million (married filing separately) and trusts with income exceeding $200,000 would pay a 5% annual income tax surcharge, while households with income in excess of $25 million (joint and individual), or $12.5 million (married filing separately) and trusts with income exceeding $500,000 would pay an additional 3% income surtax (8% tax overall).
Qualified Small Business Stock (QSBS) Limitation: This provision amends section 1202(a) to provide that the special 75% and 100% exclusion rates for gains realized from certain qualified small business stock will not apply to taxpayers with adjusted gross income equal to or exceeding $400,000. The baseline 50% exclusion in 1202(a)1 remains available for all taxpayers. The amendments made by this section apply to sales and exchanges after September 13, 2021, subject to a binding contract exception.
Limits on Very Large Retirement Accounts
So, what should taxpayers 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 ahead of rumored tax changes only to be regretted later.
There has been some concern over the possibility that tax increases will be retroactive to the beginning of 2021. While retroactive tax changes can be done for a “legitimate purpose,” they are highly unpopular and quite rare. Currently, the only retroactive tax provision is the limitation on the Qualified Small Business Stock deduction. Given the short time between now and year end, changes enacted in 2021 are more likely to be effective in 2022. There is a stronger possibility that tax increases may be effective as of the date a bill is introduced in Congress. This has been done with prior increases in order to prevent taxpayers from gaming the system.
The plethora of alternatives can be overwhelming. 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. To avoid the 5%/8% income tax surcharge, those in upper-income tax brackets may want to accelerate the realization of income into 2021. In particular, large taxable events such as the sale of a business made before December 31, 2021—rather than after—would avoid the surtax. Concurrently, you may consider funding charitable gifts with low basis stock to benefit from an immediate income tax deduction and avoid future tax on capital gains. Going forward, the use of tax-managed strategies for their investments has become increasingly important
Similarly, trustees of trusts where income could be greater than $200,000 are encouraged to consult tax counsel and work with their investment managers to explore ways to avoid or limit paying the surtax. These may include weighing the advantage of distributing income (possibly including capital gains, if permitted by statute and/or the trust document) to beneficiaries versus the benefits of retaining the income in the trusts for future growth and creditor protection outside the beneficiaries’ estates.
2. Utilize remaining gift and estate tax exemption of $11.7 million per person, or $23.4 million per couple, by making gifts outright or in trust to your heirs.
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.
The “grantor trust” status also allows the grantor to swap appreciated assets out of the trust in exchange for personally owned high basis assets, thus providing for a step-up in basis on the assets with embedded gains, which will be in the grantor’s gross estate and thus will benefit from a step-up in basis at death. Although the elimination of the strategy was included in some prior proposals, it has not been included in the latest version of the Build Back Better Act, so these traditional estate planning techniques remain available at present.
4. Manage your tax-deferred retirement accounts now and later on.
5. Interest rates are still historically low but trending up. Before possible further increases, there are a number of planning options involving the use of credit.
6. Take advantage of valuation discounts when gifting minority interests and illiquid assets before these are reduced or even eliminated.
In terms of investment portfolios, it’s important for clients not to make any changes to their long-term investment strategy just because of proposed tax policy changes – as what ultimately gets passed can look very different to today’s bill. While we continue to monitor any forthcoming tax policy changes, economic growth, inflation, interest rate moves and earnings have a far greater impact on markets than taxes.
We are positioning investment portfolios for slowing but above trend growth, tapering of stimulus and modestly higher inflation. i. Strong consumer demand, bolstered by high savings rates, will likely underpin the U.S. economy. And while the Fed is expected to hike rates in 2022 to dampen inflation concerns, borrowing conditions should remain attractive for consumers and corporates.
We remind clients that equity markets can do quite well under slightly higher interest rates, and that’s also true for higher tax rates, as we saw under the Obama administration.
For the more tax-sensitive investors, we recommend they take advantage of tax-managed equity strategies, which work to both minimize net gains and actively harvest losses to help maximize after-tax returns. The combination of staying aligned with investment plans and incorporating tax-efficient strategies can help protect and grow client wealth as we shift into a new year.
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 pertaining to if/when they may be enacted and become effective adds a further dimension to investing and planning around them. Investment decisions based solely on proposed policy changes can prove costly, so it is best to adhere to long-term investment strategies aligned to one's goals. Clients who are interested in pursuing 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.
1. Top taxpayers are defined as single filers with over $400,000 in annual income and joint filers with over $450,000 in annual income.
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