There are always proposals to change the tax code with a new presidential administration to push initiatives and programs through tax incentives. President Joe Biden’s administration is no different; while his term is at its infancy, we are starting to get a picture of some upcoming legislation that will impact taxpayers, especially those making over $400,000 per year.
Given the Democrat’s narrow control of the House and Senate, if there is an opportunity to pass a tax bill, it would be in the current window before the mid-term elections in 2022, especially if the Senate removes the filibuster. So we would assume that if a bill passed, the new rules would start in 2022 or 2023.
Hurry Up: Near Term Considerations
Higher Corporate Tax Rates
The first bill to watch regarding tax policy is the Infrastructure plan working its way through Congress. The package, if passed, will increase the corporate tax rate to 25% from 20%.
While this proposal targets large publicly traded C-corporations, it does impact small businesses organized as C-corporations. Those businesses will want to review their corporate structure with their CPA to determine if the entity type should be changed—especially when you can benefit from the benefits of the 20% pass-through deduction on S-Corporations.
Given the tax benefits of an S-Corporation when paired with the 20% pass-through deduction, it is worth revisiting now, even if the infrastructure bill fails to increase Corporate Tax Rates.
Higher Individual Tax Rates for those Making over $452,700 (Single) or $509,300 (Joint)
Additionally, we know that the Biden Administration is focusing its proposed tax hikes on taxpayers with over $452,700 single/$509,300 joint income. However, we are still unsure of the income limits as the amount has changed, but the income tax rate increase has consistently targeted those making over $400,000.
There are a few ways taxpayers who make more than $400,000 will see their tax liability increase:
- Increase in Social Security Taxes
- Social Security taxes would be paid up to $142,800 and then again on any income over $400,000.
- Increase in Tax Rates
- Changing the top income tax rate from 37% to 39.6%
- Decrease in itemized deductions
- For taxpayers above the 28% tax bracket, they will see their itemized deductions reduced as the new proposal calls for capping the deduction at 28%. Those above 28% will not get a deduction for income at the higher rates.
- The tax proposal brings back the ‘Pease Limitation,’ which reduces taxpayers’ total itemized deduction if their income is over a certain income threshold.
- Capital Gains rate
- Increasing capital gains rate from 20% to 39.6% for capital gains over $1M
Win/Win Planning Considerations
When planning for anticipated tax changes, taxpayers should take measured actions. It can be easy to get carried away with complex modifications to be ahead of the curve. But, on the other hand, planning too early can waste time, money, and energy, as the proposal never looks like the final bill.
There is a win/win opportunity here for those looking to lower their taxes. Below are some considerations that could reduce your tax bill no matter what happens.
Increase in Social Security Taxes
For those who are an owner or looking to change to an S-Corporation, it will be worth checking with your CPA if you could lower your wage income and increase your profits. The benefit is that earnings from S-Corporations are not subject to FICA taxes.
Increase in Tax Rates
With the potential for the top tax rate to increase from 37% to 39.6% (43.4% including the Medicare Tax), it could make pre-tax contributions to retirement plans less attractive today with the lower rate (37%) and much more attractive in 2022 at the higher rate (39.6%).
In this scenario, Roth contributions would allow the taxpayer to pay taxes now and have them grow tax-free for the rest of his/her life while still contributing to their retirement.
Even if the top tax rate does not change, you still put money away in an account that will grow tax-free for the remainder of your life.
Decrease in Itemized Deductions
The tax proposal includes language about capping the dollar amount of deductions a high-earning taxpayer can take. Knowing this is a possibility, it may be worth making charitable contributions into a Donor Advised Fund, which allows the deduction today (at a higher rate) rather than later at a possible lower rate.
Capital Gains Rate
With the capital gains rate potentially increasing from 20% to 39.6%, it makes selling assets such as a closely held business or real estate more attractive sooner than later. The change is so dramatic that it is worth serious consideration now, given the dollar amounts and how long it might take to sell illiquid assets.
With the combination of low rates, pending higher capital gains rate, and the baby boomer generation looking to exit their businesses, we might see a perfect storm creating an uptick in business sales in the next 12 to 24 months.
Additionally, contributions of appreciated stock or other assets to a Donor Advised Fund is a strategy worth considering now and in the possible higher tax future. The ability to avoid the capital gain AND get a deduction for a charitable contribution is a double tax win for the donor.
Wait – No Action Until a Bill is Passed
Three outstanding proposals seem unlikely to pass, and we are currently waiting to see how these ideas play out:
- Reducing the estate exemption from $11.7M per person to $3.5M per person
- Repeal of Step-Up in Basis
- Retroactive Capital Gains Tax in which the new (higher) rate takes effect 4/28/21.
Why are we waiting on these? Of all potential changes, these are the most unlikely to make it into the final bill.
The estate tax has only increased over the last 20 plus years with one minor exception (when it was repealed in 2010, then back in 2011). With several members of Congress personally impacted by the change, will we see members of the House and Senate vote against their own interests and reduce the estate exemption?
Additionally, the repeal of the step-up in basis is an extraordinary step in estate taxes. While several developed countries do not have a step-up in basis, it has been a core principle in the U.S. tax code. While certainly possible, it is not worth liquidating a position within a portfolio based on the information we have right now.
Finally, the retroactive capital gains tax is a new approach to avoid a massive sell-off. It attempts to avoid having investors sell positions at year-end to avoid higher tax bills starting in 2022. However, this type of legislation is unprecedented and highly unpopular, so we don’t see a strong likelihood that it survives to the final bill. Beyond the unfair idea of changing the game after it is played, it sets a problematic precedent for tax legislation moving forward.
Hurry Up When We Know More
Once Congress passes the bill, it will be time to hurry up once again. Considerations will need to evaluate for your tax returns, portfolios, and estate plans.
In preparation, we encourage all clients to have an updated net worth statement, ensure all cost basis is reported within their brokerage account, and determine if and how much they wish to give to the charity(ies) of their choice in the next 1, 3 and 5 years. Having this information together will help you make the changes that might be necessary with the upcoming tax changes.
If you want to discuss how the Biden tax plan will impact you or discuss ways to save taxes no matter if the proposals pass, please contact us. We would love to discuss how we can help minimize your taxes.
Editor’s note: This information was current as of June 14, 2021.