With the 2022 Fiscal Year Federal Budget deadline of October 1st rapidly approaching, House Democrats presented a preliminary tax proposal targeting high earners, wealthy estates, and corporations to fund Biden’s proposed $3.5 trillion infrastructure spending package. While the proposal is significantly more moderate than some of the proposals campaigned by President Biden last year, it will have substantial impacts for certain individuals. The good news is that most of the proposed changes will be enacted starting January 1, 2022 rather than retroactive to the beginning of this year, which allows individuals a window of time to implement estate plan updates and revise income tax strategies. Below is a summary highlighting the more significant changes and how these changes may impact clients and their assets.
For individual and married taxpayers, the marginal tax rate increase that is proposed in Biden’s plan is largely consistent with the House Democrats’ proposal. The highest marginal bracket would increase from 37% to 39.6%; however, this proposal is more progressive than originally thought as it would apply to taxable income in excess of $400,000 for individual filers and $450,000 for married filing jointly, rather than approximately $400,000/$625,000 as originally proposed.
The proposal also enacts a new surcharge on incomes in excess of $5mm for both individuals and married taxpayers. The surcharge is a flat 3% tax and would act to increase the highest marginal income tax rate to 42.6%. The $5mm threshold would also include income earned through the recognition of capital gains.
With respect to the capital gains tax, the proposal would be less punitive than originally feared. A more modest increase from 20% to 25% on long-term capital gains was negotiated instead of creating a new “ordinary income” bracket for capital gains in excess of $1mm. Unlike many of the other provisions in this proposed legislation, the 25% rate could be effective immediately upon gains recognized following the passage of the bill, which is currently expected to be on or around October 1, 2021. It is important to note that it would not be retroactive to January 1, 2021, so all previously recognized portfolio activity or any sale agreed upon prior to October 1st but executed post October 1st (i.e., signed real estate contract or agreed upon business sale) would still be subject to the 20% capital gains rate. By increasing the capital gains rate to 25%, this additional burden will apply to a broader segment of the population, not just ultra-high-net-worth investors. Additionally, the 25% tax rate would apply to qualified dividends which, under current law, are also taxed at a maximum rate of 20%.
There are also proposed changes for high-net-worth owners of IRAs, Roth IRAs, and defined contribution plans (401(k), etc.).
After the high-profile report earlier this year regarding Peter Thiel’s $5 billion Roth IRA, this proposal would limit combined tax deferred/exempt account balances to $10mm through a number of new rules that limit additional contributions and mandate required minimum distributions for the excess above $10mm. These rules are unlikely to affect many taxpayers, but more broadly, this legislation would also restrict IRA accounts from holding investments limited to accredited investors. This would apply largely to hedge funds, private equity funds, and private placement deals available only to high-net-worth individuals or educated investors. Taxpayers will have two years to become compliant with the new restrictions, but this could have lasting impacts on existing equity investments held in IRAs.
Even more broadly, this proposal targets Roth IRA conversions for high income individuals ($400k+) and could be the end for the “back-door” Roth IRA by eliminating the ability to convert a taxable IRA contribution into a Roth account.
For many individuals, the implications of the changes to the estate tax landscape may be more significant than on the income tax side. To start, the Unified Gift & Estate Tax Exemption, currently $11.7mm per individual, is set to be reduced to the 2010 baseline exemption amount of $5mm per person, indexed for inflation (approx. $6mm in 2022). This will increase the number of estates subject to estate tax and will re-emphasize the use of permanent life insurance as a planning tool to offset an estate tax burden.
The proposed legislation also aims to curtail the use of certain estate planning tools like valuation discounts, which allow taxpayers to transfer ownership of property to future generations for less than the “fair market value” due to restrictions on those assets, such as lack of control or marketability. It would also limit the use of Intentionally Defective Grantor Trusts, which allow the grantor to retain certain powers or control over assets gifted to a trust. These are two examples of estate planning strategies Congress has looked to eliminate as “loopholes” in the existing Internal Revenue Code.
Corporate & Business Taxes
After the 2017 Tax Cut & Jobs Act reduced the corporate tax rate from 35% to 21%, a major focus of the Biden administration had been on increasing the corporate tax rate and reducing the number of mega-cap companies that pay little to no income tax. The current proposal is to create a progressive corporate income tax, similar to what is currently used to calculate personal income tax. The corporate tax rate would begin at 18% on income up to $400,000, increase to 21% on income between $400,000 and $5mm, and then be taxed at 26.5% on amounts in excess of $5mm. Corporations with more than $10mm in income would lose the benefit of the lower graduated rates, creating a “corporate tax cliff” that could be costly if not managed properly.
Correspondingly, the proposal also targets businesses established as flow-through entities with respect to a limitation of the Qualified Business Income deduction to $500k for married and $400k for individual investors. Created as part of the 2017 Tax Cut & Jobs Act, The Qualified Business Income deduction is currently uncapped but is limited to specific industries and excludes many “professional service” businesses.
The proposals have also placed greater emphasis on limiting income tax deductions and increasing the taxability of multi-national corporations with subsidiaries overseas.
What Isn’t Included
Notably missing from the House Democrats’ proposal is the elimination (or potentially a dollar amount limitation) of the “step-up” in cost basis at death. This is a significant omission for older investors with large built in capital gains in their portfolio or on investment properties.
Similarly, there had been discussion of limiting or eliminating the popular 1031 exchange, which allows real estate investors to defer the recognition of capital gains by rolling the proceeds of the sale of property into the purchase of a new property. These provisions did not appear in the more recent proposal.
Reforms to Social Security are also notably absent in the current proposal, but that may be rationalized by the fact that the Social Security Trust Fund operates independently of the federal budget, so this may be a lower priority item following the agreement on the federal budget. With recent analysis suggesting the trust fund will be exhausted sooner than anticipated due to the COVID-19 pandemic, changes in the payment of benefits or the income base will be necessary.
With two weeks until the budget deadline, it is likely these proposals will be revised further to gain the votes necessary in both the House and Senate. For an analysis of how these proposals may impact your personal situation, please reach out to a Round Table Wealth Advisor.