Biden’s Tax Reform – What Family Offices Need to Know

Now that Congress has approved a budget resolution, they are in the process of hashing out specifics through the reconciliation process. The goal is to complete this by the end of September. There will be negotiations on the details, but the starting point is President Biden’s budget proposal. While it is still unclear what adjustments Congress will make, it is worth considering the suggested budget changes and how they might impact you. Outlined below are proposed changes to high-income taxpayers and an assessment of who might be impacted.

Raise the top marginal income tax rate: The proposed budget resurrects the 39.6% income tax rate earlier than scheduled. The Tax Cuts and Jobs Act of 2017 reduced the top marginal tax rate from 39.6% to 37%. This change is scheduled to last through 2025, reverting to the former rates in 2026. President Biden’s proposal renews the 39.6% tax rate as of January 1, 2022. If the proposal is passed, joint taxpayers with taxable income over $509,300 and individual taxpayers with income over $452,700 next year would pay a marginal tax rate of 39.6% on ordinary income in excess of those amounts.

Tax capital income for high-income earners at ordinary income tax rates: Currently, long-term capital gains and qualified dividends get preferential tax treatment. They are taxed at lower, long-term capital gains tax rates than the ordinary income tax rates applied to earned income, such as wages. Long-term capital gains tax rates are 0%, 15% and 20%. Biden’s tax proposal would add another long- term capital gains tax rate for high-income taxpayers. Once taxable income exceeds $1 million, long- term capital gains and qualified dividends would be taxed at the ordinary income tax rate of 39.6%. In addition, this income would still be subject to the 3.8% net investment income tax (NIIT), effectively imposing a 43.4% tax on portfolio income over $1 million. (Taxpayers in the 15% or 20% long-term capital gains tax rate are also subject to the NIIT tax if their taxable income is over $250,000 for a married couple filing jointly or $200,000 for a taxpayer filing single.)

This particular change is scheduled to go into effect “after the date of announcement”. Unlike the other proposed tax changes, the impact would not be postponed to the 2022 tax year. There is no clarification as to what the date of announcement refers to. It could be when Biden released his American Families Plan in April or when he announced his budget in May. Alternatively, it could be as of the date the budget is approved.

Eliminate the step-up in basis and treat transfer of property by gift or death as realization events:

Currently, assets transferred upon the death of the owner receive a step-up in basis from the original value to the fair market value on the date of death. This means that the person inheriting the asset doesn’t owe any tax on the asset and their “new” basis moving forward is the fair market value at the time of death. Biden’s tax plan eliminates the step-up in basis. Furthermore, death is to be treated as a realization event, meaning the estate would have to pay taxes on the difference between the fair market value and the basis of the asset. Gifting of assets would also be treated as a realization event, making it difficult to avoid gains by gifting prior to death.

There are exceptions to this proposal. The capital gains tax from realization events would not have to be paid on family owned and operated businesses until they are sold or are no longer family operated. Also, a 15-year period would be granted for payment of taxes on illiquid assets. Finally, each taxpayer would be allowed a $1 million exclusion from recognition of gains plus another $250,000 exclusion for their primary residence. For married couples, there is no tax on assets transferred to a spouse and the exclusion is portable. The exclusion amount would be indexed to inflation.

The impact of proposed changes will depend upon your specific circumstances. However, we provide a few thoughts about the potential new taxes:

■ Most people won’t be impacted by the new taxes: President Biden is determined to not raise taxes on those with income under $400,000 and the new income tax rate applies only to incomes higher than that amount. Similarly, the new capital gains tax rate would only apply to those with income over $1 million. The end of the step-up in basis would impact only estates with taxable accounts holding unrealized gains in excess of the exclusion amount. Retirement accounts would not be impacted by the elimination of step-up in basis

■ There are no proposed changes to the estate tax: One item not included in Biden’s budget proposal is changes to the estate tax exemption. TCJA raised the estate exemption amount from $5.49M to $11.18M in 2018 (the amount is indexed, so it is now $11.7M). The increase is set to sunset in 2026, dropping back to $5M, adjusted to inflation. The 2022 budget proposal maintains the schedule set by the TCJA. However, this may be an alternative way to raise taxes if the other tax proposals are cut back.

■ The elimination of step-up in basis is key: Limiting the step-up in basis would remove a major planning strategy. Given the uncertainty regarding the effective date, realizing gains before the tax law is put into place may not be possible. Instead, new strategies could be adopted such as annual filling in of lower brackets, rethinking asset location or filing taxes separately.

Take the time now to consider whether you might be impacted by the proposed changes. If so, review the above considerations with your financial and tax advisors and develop an appropriate plan of action.

For information, contact Monica Jalife, CFA, CFP, Pinnacle Associates, Ltd. at 212-652-3250 or [email protected]