Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

Profile Photo
Daniel F. Rahill, LL.M, CPA, J.D.
Managing Director
Wintrust Wealth Services
 

If Democratic presidential nominee Joe Biden wins, his administration is likely to try to roll back many of the 2017 tax cuts, including the $11.58 million gift and estate tax exclusion amount, and increase capital gains and payroll taxes on top earners. If President Trump wins reelection, he is likely to make the 2017 tax cuts permanent and reduce the long-term capital gains tax rates through indexing.

There is no guarantee that any of these policy proposals will be adopted as they appear today—or at all—but experts agree that current tax rates for both individuals and corporations are historically low and many are scheduled to sunset after 2025. Higher taxes appear inevitable with the mounting fiscal pressure to pay for COVID-19 relief measures—currently totaling over $3 trillion. Following is a summary of how Biden’s tax policies differ from Trump’s and how to plan for the unknown.
 

Impact on Individual income

Biden
For most individuals, Biden’s most impactful proposed changes are to personal income tax rates, which would return the current 37 percent top rate to the pre-TCJA level of 39.6 percent for taxpayers with incomes above $400,000. Not to be overlooked is the Biden plan change to the brackets as well, for example the current 37 percent bracket starts at $622,050 of taxable income in 2020 while the proposed Biden top 39.6 percent bracket would start at the $400,000 income level resulting in significantly more tax. Additionally, Biden would limit total itemized deductions so the reduction in tax liability per dollar of deduction does not exceed 28 percent. This means taxpayers in tax brackets higher than 28 percent will face limited itemized deductions. Someone with $40,000 of itemized deductions in the new 39.6 percent bracket would therefore see their deductible itemized deductions reduced to $28,283.

Additionally, itemized deductions for those with income over $400,000 would be further limited by restoring the pre-2018 Pease Limitation. This would reduce itemized deductions by 3 percent of AGI over the threshold—up to 80 percent of itemized deductions. A married couple with $1,000,000 of AGE and $40,000 of itemized deductions would see the amount of these deductions reduced to $22,000 under the Pease Limitation. Since this amount is below the $24,800 standard deduction, this couple would default to the standard deduction, impacting their charitable contribution, mortgage interest and perhaps state and local tax decisions.

Trump
Trump proposes a 10 percent tax cut for the middle class, which may include lowering the 22 percent marginal tax rate to 15 percent, which in 2020 applies to income over $40,125 for individuals and $80,250 for married couples filing jointly. He also proposes to permanently extend the current lower individual rates and the higher basic standard deduction enacted by the TCJA that are scheduled to expire after 2025.

Planning Considerations
A lower income tax rate is generally favorable for Roth IRA conversions to lock in lower tax rates on pre-tax retirement savings. Deduction deferrals and income acceleration strategies—such as capital gains harvesting—are sound recommendations in anticipation of rising tax rates.

If Biden restores the state and local tax deduction for amounts above the current $10,000 cap, itemizers should plan to defer payments of these taxes until after the law change. However, taxpayers should be cautioned that the potential benefit of this SALT deduction deferral would be reduced or offset by the 28 percent top rate benefit ceiling and the restoration of the Pease Limitation noted above.
 

Impact on Investment Income and Capital Gains

Biden
Under Biden’s plan, the tax rate on long-term capital gains and dividends would increase from 20 percent to 39.6 percent for taxpayers with income above $1 million. This income would also continue to be subject to the 3.8 percent net investment income tax as enacted in the Affordable Care Act. This would have a significant impact for high-income investors as well as founders and entrepreneurs who may experience a liquidity event. Individuals with highly appreciated assets may consider hedging the tax rate by selling some of those assets before any rate increase comes into effect.

Biden also supports a financial transaction tax on trades of stocks, bonds, and other financial instruments, but has not released further details. Of note; however, is that vice presidential candidate Senator Harris has proposed imposing a financial transactions tax on stock trades at 0.2 percent, bond trades at 0.1 percent, and derivative transactions at 0.002 percent.

Trump
Trump says that he is “very seriously” considering a capital gains tax cut through indexing capital gains for inflation. He has also proposed a capital gains tax holiday that eliminates capital gains taxes for a yet-to-be-determined period.

Planning Considerations
Investors with incomes over $1 million should consider selling appreciated assets before the 20 percent preferential rate for long-term capital gains and qualified dividends is eliminated. Another effective capital gains tax mitigation strategy is gifting appreciated assets to utilize the current increased estate and gift tax exemption. Similarly, charitable contributions of appreciated assets to qualified charities, including donor-advised funds and private foundations, is also an effective way to sidestep the capital gains tax on disposition.

Reinvesting realized capital gains into qualified opportunity zone funds is another strategy—with both benefits and risks. The benefits include the ability to defer a current capital gain to 2026, avoid 10 percent of that current capital gain if it is held for five years, and permanently avoiding all future capital gains after the contribution is held for 10 years or more. If capital gains rates significantly increase under a Biden administration, the ability to completely avoid capital gains using and opportunity zone fund will become an extremely popular tax planning strategy for long term investors who can hold assets for more than ten years. One small risk, however, is that the 10 percent deferred capital gain portion is subject to whatever capital tax rate is in effect in 2026, which could be a substantially higher rate than it is today.
 

Payroll Taxes

Biden
Biden seeks to eliminate the Social Security tax exemption for wages and self-employment earnings above $400,000. Therefore, wages and earnings between $137,700 and $400,000 would not be taxed, creating a donut-hole structure. Because the 12.4 percent Social Security tax is split evenly between the employer and the employee, this proposal would increase payroll taxes not only for higher-income wage earners, but their employers as well. For example, a doctor earning $1 million per year and paying both employee and employer portions of the FICA tax would see their payroll taxes increase by $74,400 ($1 million less $400,000, times the 12.4% tax rate.

Trump
Trump, facing an impasse on Capitol Hill over coronavirus relief, issued an executive directive on August 8 to delay the deadline to submit payroll taxes for millions of workers until the end of the year. He said he hopes Congress will forgive those tax debts, but absent legislation, those payments will still be required by the extended due date.

Planning Considerations
Should the Social Security tax be expanded, business owners could consider converting to an S corporation structure, as S corporation dividends are not subject to employment taxes. Assuming that reasonable compensation rules are met, this would be a viable solution to this potential payroll tax increase. As for executive compensation, incentive stock options would likely become more popular because there is no Social Security tax on the option spread.
 

Estate and Gift Tax Changes

Biden
Biden’s estate taxes are his most dramatic proposals. The current estate tax exemption threshold is $11.58 million per individual (indexed for inflation) with a top tax rate of 40 percent. This amount is scheduled to revert to the pre-Tax Cuts and Jobs Act (TCJA), which was an indexed amount of approximately $5.8 million after 2025. The Biden-Sanders Unity Task Force has recommended returning the estate tax regime to the “historical norm,” which could mean restoring the exemption threshold to the 2009 level of $3.5 million per individual and an estate tax rate of 45 percent rate, or possibly even higher.

Likely the single most significant Biden proposal is a proposed change to the estate tax regime. Currently, a future capital gains tax upon disposition of an asset is based on its value at the time it’s inherited, referred to as the basis “step-up”. Biden’s plan would eliminate the step-up in basis for inherited assets. The Biden plan is not entirely clear whether the proposal would provide the heirs with a carryover basis or impose capital gains tax on the decedent for unrealized appreciation at the time of death, which was one of President Obama’s budget proposals. If heirs receive carryover basis, capital gains tax would be imposed on the heir based on the value of the asset from the time the original investment was made. The result would often lead to a significantly higher income tax liability for the heir, should the inherited asset be sold. If the proposal is to tax unrealized gains of the decedent, the decedent’s estate would pay the tax, and presumably the heirs would take the assets at a basis stepped-up to fair market value.

Trump
Trump’s plan would extend the higher estate and gift tax exemption enacted by the TCJA that is scheduled to expire after 2025.

Planning Considerations
The Department of the Treasury confirmed that the temporarily increased estate and gift tax exemption would not be clawed back for taxpayers who die after 2025, but the increased amount is a use-it-or-lose-it proposition. This encourages taxpayers to act now to take advantage of the current increased exemption before the law changes or reverts in 2026 as planned. For example, an individual with a 2020 exemption of $11.58 million who only utilizes $9 or $10 million of that exemption through 2025 will lose the unused exemption amount above the $9 or $10 million in 2026 when the law reverts to pre-TCJA law, or earlier if a new Biden lower exemption limit is passed. Assuming Trump’s plan is not enacted, taxpayers with more than the full $11.58 million exclusion amount should plan to gift their full exclusion amount before the exclusion amount reverts to a lower threshold.

Considering either a capital gains tax on assets held upon death or upon the later sale of inherited assets by the heirs who obtained a carryover basis, Biden’s proposal would create significant practical problems in establishing the tax basis of long-held assets and investment assets. As tax legislation can be retroactive, it is critically important that taxpayers with estates worth $11.58 million or more in value and/or with significant appreciated assets, carefully consider and implement a wealth-transfer plan prior to enactment of a Biden plan. If Trump wins the election, those taxpayers with $11.58 or more estates have until the end of 2025 to utilize the higher exemption before it reverts back to per-TJCA levels.
 

Elimination of Like-Kind Exchanges for Real Estate

The TCJA repealed a like-kind exchange treatment (Internal Revenue Code Section 1031) for personal property. However, the new like-kind provision allows investors to defer tax on gains from sales of real property by rolling the sales proceeds over into a subsequent real property purchase. Biden’s plan would repeal the like-kind exchange treatment for real property for taxpayers with income over $400,000.

Planning Considerations
Retroactive tax legislation is very possible and a repeal of like-kind exchange treatment could be effective as early as January 1, 2021. Taxpayers with real estate contemplating a Section 1031 like-kind exchange should complete their transactions to defer their tax gains prior to the effective date of repeal.
 

Retirement Plan Tax Deductions

Biden
Biden proposes a modification to how retirement accounts are treated, shifting the benefit of the tax deferral toward lower and middle income earners. He proposes to convert traditionally deductible contributions into matching refundable tax credits for 401(k)s, IRAs, and SIMPLE accounts, providing a 26 percent refundable tax credit for each $1 contributed.

Trump
Trump proposes no changes to the retirement plan deductions.

Planning Considerations
Roth tax treatment would be unaffected and therefore, higher income taxpayers would shift to more Roth-style accounts.
 

Impact on Businesses

Biden
The largest source of new revenue from Biden’s proposal is an increase to the corporate tax rate, bumping it from 21 percent to 28 percent. Vice presidential candidate Senator Harris went further during her presidential campaign, proposing a 35 percent corporate tax rate. Biden would create a new alternative minimum tax of 15 percent on global book income for corporations with over $100 million in book net income. Biden’s plan would also increase the tax on foreign profits, doubling the tax rate on global intangible low-taxed income from 10.5 percent to 21 percent for companies operating in the U.S. and abroad. In a major blow to pass-through entities, he would also phase out the Section 199A 20 percent pass-through deduction for those with income over $400,000.

Trump
Trump is campaigning on making certain expiring provisions of the TCJA permanent, including the 20 percent tax deduction for pass-through entities and the 100 percent bonus depreciation that is schedule to begin phasing-out in 2023. Trump would retain the current deduction for research and development that is scheduled to expire after 2021.

Planning Considerations
Facing potentially rising tax rates and a new corporate alternative minimum tax, corporations should consider income acceleration techniques and capital improvement projects before rates rise. The new alternative minimum tax on corporations negates the benefits of accelerated and bonus deprecation critical to capital intensive industries. Entities should plan major improvements prior to the enactment of a Biden plan. Rising corporate rates will also prompt many organizations to revisit their business entity structure to determine whether a partnership or LLC would be more advantageous than a C corporation.
 

Potential Planning Strategies for Tax Changes

The 2016 election showed us it is impossible to predict an election’s results, and whether any of these proposals become law depends not just on the election’s outcome, but on which party controls Congress. Taxpayers, investors, and business leaders can take the following steps now to prepare for possible retroactive tax law changes.

Individual Tax Bracket Management:

  • Accelerate bonuses and recognition events to avoid rate increases
  • Consider Roth Conversions before rates increase
  • Consider non-qualified deferred compensation and stock option plans to avoid rate increases and increased
  • 12.4 percent payroll taxes
  • Harvest gains and defer losses in anticipation of rising capital gains rates from 20 percent to 39.6 percent
  • Sell your gains in a current year and pay lower taxes
  • Repurchase the same or similar assets
  • Consider the time value of the prepayment of tax
  • Consider that capital losses are more tax effective if they offset income tax at higher rates
  • Do not forget the 30-day wash sale rule
  • Election out of Sec. 453 installment sale provisions for intra-family sales

Opportunity Zones:

  • Basis adjustment of 10 percent or 15 percent
  • Deferral of gain to 2026
  • Permanent elimination of gain if held for more than 10 years from investment
  • Should future capital gains rates increase, the popularity of Opportunity Zones will follow

Roth IRA Conversions:

  • Consider special favorable tax attributes that need to be consumed such as charitable deduction carry-forwards, investment tax credits, NOLs, etc.
  • Expect the converted amount to grow significantly
  • The current marginal income tax rate is likely lower than at distribution
  • Cash outside the qualified account is available to pay the income tax due to the conversion
  • The funds converted are not required for living expenses, or otherwise, for a long period
  • The client expects their spouse to outlive them and will require the funds for living expenses

Planning for Business Income Tax Increases:

  • Defer business expenses to capture a greater benefit if rates increase
  • Consider what reinstatement of the AMT and doubling GILTI tax would mean
  • Complete Sec 1031 like-kind exchanges for real estate before law changes

Payroll taxes:

  • Consider converting to an S-corporation structure, since corporate dividends are not subject to 12.4 percent employment taxes
  • Incentive stock options have no social security

Planning for Itemized Deduction Changes:

  • Carefully consider property tax payments
  • Defer to capture a greater benefit due to higher rates
  • Defer in-case the $10,000 SALT deduction cap is repealed
  • Accelerate non-tax itemized to avoid additional 28 percent and 3 percent itemized deduction limits
  • Carefully consider charitable contribution timing:
    • Defer to capture a greater benefit due to higher rates
    • Accelerate to avoid additional itemized deduction limits.
    • Note: the CARES Act allows for a contribution of cash up to 100 percent of AGI. This does not apply to Donor Advised Funds or Supporting Organizations.

Planning for Estate and Gift Tax Changes:

  • Use a lifetime gift exclusion and GST exemption prior to the date of tax increases
  • Married couple’s unable to gift the full $23.16 million, should fully utilize one spouse’s exclusion first
  • Gifts to an intentionally defective grantor trust (IDGT) or spousal lifetime access trust (SLAT)
  • Retain flexibility by structuring a transfer to IDGT as an installment sale in exchange for a promissory note:
    • If Biden’s plan materializes, forgive notes quickly, completing the gift
    • If status quo remains, maintain promissory notes
    • If the Grantor changes its mind on gifts, pull assets back by calling the notes
  • If the “step-up” in basis at death is retained, many people will be substantially more encouraged to hold onto assets until death
  • If the “step-up” in basis at death is repealed in-favor of a forced-recognition event, people will be encouraged to recognize gains before death to:
    (a) Find better investments and;
    (b) Avoid a 39.6 percent applying in the year of death instead of a 20 percent rate during life

 

 

 

Information and opinions presented have been obtained or derived from sources believed to be reliable, however, there is no guarantee as to their accuracy or completeness. Wintrust accepts no liability for loss arising from the use of this information. Nothing in this presentation constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to your individual circumstances.

This information may answer some questions, but is not intended to be a comprehensive analysis of the topic. In addition such information should not be relied upon as the only source of information, competent tax and legal advice should always be obtained.