With the results of the Georgia runoff election in the Democrats Control the House, the Senate and the White House. So, the potential for harsh tax legislation increasing taxation of the wealthy, along the lines of prior Democratic proposals, might be likely to happen. What might those changes be? When might they be effective? What planning might you want to do now?
How Do the Dems “Control” the Senate?
The Senate is 50/50 Dem/Republican so that does not sound like control. But Kamala Harris will cast the tie-breaking vote and that equates to control. Might that suffice to push through major tax legislation? Certainly, and it would not be the first time. In 2001 Vice President Chaney cast deciding vote and pushed through significant tax changes, and we may face similar situation this year
Be Wary of Retroactive Estate Tax Changes
That is not fair. How can Congress retroactively change the tax rules? Well, it may feel unfair, but it is legal to do and Congress might choose to do it! One of the tax changes that some commentators suspect might be retroactive is the reduction in the transfer tax exemption (the amount you can gift or bequeath without incurring a gift, estate or generation skipping transfer tax without trigger tax). While nothing can be known, there have been several cases holding that retroactive changes are legal.
For a retroactive change in the law to be respected, it must be rationally related to a legitimate legislative purpose. Raising revenue in the midst of a pandemic with historic bailout packages would seem easily sufficient to meet this requirement. Pension Benefit Guaranty Corporation v. R. A. Gray & Co., 467 U. S. 717 (1984); United States v. Carlton, 512 U.S. 26 (1994).
So, when planning what type of wealth transfers you might complete this year, in hopes of beating any future tax legislation effective dates, you need to consider the risk of some changes being enacted retroactively. That is important, as it can and perhaps should, affect how you make wealth transfers in 2021. That will be described below.
Be Wary of Retroactive Income Tax Changes
Retroactive tax changes could also affect income tax changes. That might be less likely than estate tax changes being retroactive. That could be because of the complexity a retroactive income tax change might create (but do not read that as implying it cannot happen). Income taxes are paid in quarterly through estimates. A retroactive change could adversely affect the amounts taxpayers paid in through withholding taxes and estimated taxes all based on prior law. In contrast, estate taxes are due nine months following death so that a retroactive change might be a tad cleaner.
Example: You own commercial real estate and are considering a Code Section 1031 so-called “like-kind” exchange. This is where you swap or exchange an investment property for another real estate investment property and do not trigger gain recognized currently for income tax purposes. Under current law you can exchange real estate instead of selling it and avoid any current income tax costs. A repeal of section 1031 may be on the tax agenda. It has been talked about before. So, if you plan a 1031 like kind exchange you might be careful as Congress might enact a repeal (or restriction) and might make the change retroactive to January 1, 2021. So, you might wish to discuss with your real estate attorney whether it is feasible to incorporate into the contract documents that the transaction will be automatically void if the law changes before the transaction is consummated.
Some of the Possible Income Tax Changes
There could be a myriad of income tax law changes that the new administration will enact. The discussion below summarizes a few of the likely changes a Biden Administration might try to enact. Some of these changes could have a profound impact on estate, charitable and other planning as well. The tax increase changes will generally if not exclusively be targeted at higher income and higher net worth taxpayers. Several of the changes might be targeted at those earning $400,000 plus, some at $1 million plus.
Capital Gains Tax
Capital gains could be raised substantially. They have discussed doubling the tax on capital gains by taxing capital gains as ordinary income. It could even be worse as those gains could be subject to the 3.8% net investment income tax. Add to that state income tax if you live in a high tax state. So, the effective tax on capital gains over $1 million could exceed 50%. If this is enacted prospectively expect a tremendous amount of sales of assets before the effective date of that change.
Some commentators have speculated that a capital gains tax could also be made retroactive to January 1, 2021, but many think that is unlikely. Others suggest that such a change might be made effective January 1, 2022. Or there could be an effective date based on the date of enactment of the tax legislation. This will affect planning dramatically. It might prove to be advantageous to sell appreciated assets now and lock in the current capital gains tax rate.
If you sell assets on the installment basis you would pay tax when the proceeds received. You might instead prefer to elect out of the installment sale treatment for income tax purposes so that you have a gain recognized at the current and perhaps lower capital gains rate.
If capital gains rates are increased on gains over $1 million then consider the use of charitable remainder trusts (“CRTs”) to smooth out or reduce income. CRTs are exempt from tax. So, if you gift appreciated stock into the CRT and the CRT sells it no gain is recognized at that time. If you use a NIMCRUT you can postpone gain for up to 20 years. Perhaps rates may be lowered again in the future.
Another common income (and estate) tax planning technique is the use of a charitable remainder trust or “CRT.” With a CRT you can donate appreciated stock to a CRT. The CRT can sell the stock without realizing gain since CRTs are tax exempt. As you receive your periodic payments from the CRT (e.g., a unitrust payment) the payments to you will flow out income from the CRT to you. In other words, the cash flow distributed by the CRT to you as part of your periodic payments will be characterized based on the income earned by the CRT. So, if your CRT sold appreciated stock and realized a capital gain, that gain would flow out to you over many future years. If the capital gains tax rate is increased in those future years, using a CRT today might effectively defer your realization of capital gains income to later years when the tax rate is higher.
Should You Sell Assets Before Capital Gains Rates Increase?
It may prove advantageous to sell some of those appreciated assets in 2021 if the law change increasing capital gains to ordinary income tax rates only takes effect in 2022. When evaluating the guesstimated cost/benefits of selling now versus waiting also consider possible state income tax costs and planning. It may be advantageous to shift assets into an intentionally non-grantor (“ING”) trust in a trust friendly (i.e., no tax) jurisdiction so that state income tax can be deferred or avoided. You might for example, provide in such a non-grantor trust that distributions can only be made to a spouse with the consent of an adverse party. That mechanism may permit a spouse to benefit from trust assets, not undermine characterization as a non-grantor trust, and still permit avoiding state income tax on a large sale to avoid an increase in the capital gains tax. Note that in Rev Proc. 2021-3 the IRS will no longer rule on ING trusts so caution is in order. A non-grantor trust can be structured as a completed gift or incomplete gift. You can transfer assets to an incomplete gift trust if you have used all exemption, and still create a structure to avoid the state income tax on the sale. If you have exemption remaining that you want to try to use you can structure the non-grantor trust as a completed gift. Lots of options, but keep in mind the uncertainty, risk of retractive change, etc.
Charitable and other deductions might continue to be allowed under a Biden tax proposal, but the benefit may be less than initially perceived because of some of the limitations discussed later. Under current law you may receive a 50-100% charitable deduction, but all deductions are proposed to be limited to a 28% maximum benefit. In other words, if you are in a 39.6% the benefit of the contribution deduction might be capped at 28%. The Pease rule, discussed below, might also be reintroduced.
Social Security Base May Increase: If you earn compensation income of up to $142,800 under current law you would pay 12.4% Social Security tax on that income. But Biden proposals might leave a gap from that amount up to $400,000 on which no Social Security tax is paid. But once you reach $400,000 of income the 12.4% Social Security would again apply. So, under one Democrat proposal, if enacted, If you earned $1 million there would be another $74,000 of just Social Security taxes on those earnings (combined with the 39.6% income tax and state income tax). One approach to reduce this tax burden has been to organize as an S corporation and take some portion of earnings as salary subject to Social Security, and the remaining portion as S corporation dividends. But the IRS has been very successful in attacking many of these plans under a “reasonable compensation” approach. The taxpayer will have to take out a reasonable salary of what a similar executive might earn. Congress might close this planning technique down by saying if you are a personal service provider, e.g., a doctor, lawyer, architect, etc. you may not be able to do this.
Marginal Tax Rates May Increase: How might rates look? Today’s maximum income tax rate is 37%. President elect Biden’s proposal might increase this to 39.6% marginal rate. But also consider that certain investment income might still be subject to the net investment income tax (“NIIT”) of 3.8% making the effective rate higher still. Income tax rates have not generally been made effective retroactively as it makes tremendous complications with withholding and estimated taxes. So, the end of 2021 Roth conversions, accelerating gains, etc. may become commonplace.
Pension and Retirement Plans: Consider what might happen with pensions? They might restrict benefit of deduction to 28%. Consider that if you put money into a pension and can only get 28% benefit but when you retire and take income out it will be taxed at 39.6% will it make any sense? One problem is it is very tough to project what marginal tax rates will be in the future. Also note that qualified plan assets and IRAs (depending on state law) may provide asset protection from creditor claims. Thus, some taxpayers who are particularly concerned about liability issues might opt to maximize pension contributions even if not optimal from an income tax perspective.
Pease Limitation: May further restrict itemized deductions.
199A: This special deduction that permits a deduction to reduce the taxation of many businesses might be restricted. One possibility is that when you hit $400,000 of income the deduction may be reduced.
Corporate Tax Rates: These may jump from 21% to 28%. That might change the calculus of when to create a C corporation versus using a pass-through entity, what format to hold assets in, etc.
Roth Conversions: If income tax rates will increase, perhaps it is advantageous to convert a regular IRA to a Roth IRA and pay the tax now at lower rates. Consider charitable contributions, loss carryforwards and other ways to offset some of the gain if you convert an IRA to a Roth IRA. Many people do their own tax returns and get their advice on planning for IRA custodians that provide packaged investments. These taxpayers may not be able to get the sophisticated advice that is customized to their unique situation. Consider the impact of state income tax on a Roth conversion. That could also have an impact. There is no NIIT on a conversion. You also want to use funds outside the plan to pay the income tax. Roth’s provide tax free compounding which can be very valuable. Whatever you do with your retirement plan assets review your beneficiary designations in light of the Secure Act that was enacted in 2019 if you have not already done so. Most beneficiaries will no longer qualify for the so-called “stretch” payout so you need to evaluate the new options and perhaps update trusts and beneficiary designations.
Other Possible Income Tax Changes
There are many other changes that have been noted in various Democrat proposals, and no doubt the sausage making process that tax legislation is will result in a unique mix of many impacted income tax rules.
Step-Up In Income Tax Basis on Death
When you die most assets you own, under current law, have their income tax basis adjusted to equal the fair market value of the asset at the date of your death (or in certain circumstances 9 months later). So, if you purchased stock for $1,000 that is now worth $100,000, the step up would eliminate the entire capita gain if your heirs later sell it.
President Elect Biden has indicated he might eliminate the step up in income tax basis on death under Code Section 1014. That might revert to the tax system to what is referred to as a “carry over basis” system. So, the $1,000 you paid for the $100,000 of stock would carry over as the basis to your heirs. Worse, there is the possibility that a Biden administration might try to enact in the alternative a system analogous to the Canadian estate taxation regime where there is a capital gain tax assessed on death. There might be a combination of approaches, perhaps giving taxpayers an option to choose to remain subject to an estate tax and thereby also obtain a step up in income tax basis, or to instead face the loss of step up and avoid a capital gains tax on death. A recognition of gain at death would a be very far-reaching change that will have a significant impact on planning.
Consider that under current law many who are elderly or infirm intentionally hold highly appreciated assets until death to obtain a basis step up. In some instances, taxpayers create lines of credit to borrow against appreciated securities to avoid selling them. If a capital gains cost will be triggered on death that may eliminate the incentive to hold assets changing many estate planning, investment and other decisions.
Reduction in Gift, Estate and GST Exemption Amount
The exemption is an amount that you can transfer without incurring a gift, estate or generation skipping transfer (“GST”) tax cost. The current exemption for all three of these taxes is the same at $11.7 million in 2021. There are Democrat proposals to reduce the estate and GST tax exemption from $11.7 million to $3.5 million or $5 million (perhaps inflation adjusted or not). It is not clear what might occur, but a reduction seems likely according to many commentators. It might even be reduced lower. Will this be made retroactive? No one knows. While it certainly seems inherently unfair to make such a change retroactive (you made a gift thinking it was tax free then a retractive change might make it taxable) that might occur. Of all changes to the estate tax rules that might be retroactive this is suggested by some commentators to be one of the more likely. Such a change will profoundly change estate planning and subject millions of taxpayers now unaffected by estate tax, to the tax. The critical and urgent planning message of this possibility is that for those taxpayers that did not consummate estate tax transfer planning before the end of 2020, or who did not do as much as perhaps they should have, they should act immediately. There is no assurance that planning will succeed given the uncertainty about the effective date of any such changes. It would also seem that the longer you wait in 2021 to plan, the greater the risk that a change in the law may become effective before you complete your planning.
How to Use Exemption Now While You Can (Maybe!)
What is the efficient way to use exemption now? Gifts to irrevocable trusts are the preferable way to give. A robust trust can provide considerable flexibility. For example, the trust may include a disclaimer provision that could be used to unravel the gift if it is determined to be undesirable, the law does not change or that there is a retroactive change in the law rendering a non-taxable gift taxable. The trust might also provide flexibility to shift income among a class of beneficiaries which could be useful depending on the other income tax changes that are enacted. Be certain to carefully consider how much access you can directly or indirectly have to assets transferred to a trust. On one hand, you want sufficient access so that you do not face financial hardship. But any means of access, on the other hand, needs to be balanced against the increased risk of IRS challenge to the plan or a creditor being able to reach the transferred assets. Means to access assets in an irrevocable trust might include making a spouse a beneficiary, creating a self-settled domestic asset protection trust (“DAPT”) that you are a beneficiary of, creating a so-called “hybrid-DAPT” which is a trust for heirs (e.g., for spouse and descendants) for which you are not a current beneficiary but to which someone acting in a non-fiduciary capacity can add you as a beneficiary), etc.
What do taxpayers do that cannot easily transfer “assets” to use the exemption now? It may be possible to borrow against the assets and gift the cash borrowed to a trust. That may shift value out of your estate using exemption and the asset that could not be transferred (e.g., because of legal restrictions) remains in your estate but is reduced by the amount of the borrowing, thus lowering your taxable estate.
Grantor trusts are the foundation for many estate planning techniques. Grantor trust are trusts for which the income is attributable to the settlor so that the settlor not the trust pays income tax on trust income. Revenue Ruling 85-13. Thus, you can sell assets to a trust that is a grantor trust as to you, and not recognize gain for income tax purposes on that sale. There are Democrat proposals to include assets held in grantor trusts asset in the settlor’s estate on death, or to subject assets in such a trust to immediate gift tax if the tax status of the trust is changed.
Planning to Address Possible Retroactive Change in Exemption: What if you make a gift and Congress retroactively changes the exemption? The exemption today is $11.7 million. You gift that amount, to safeguard and preserve your entire exemption, to a trust. In June Congress passes new tax legislation and makes the gift exemption a mere $1 million retractive to January 1, 2021. Did you just make a $10.7 million taxable gift? Seems that way. What can you do to avoid or mitigate this possible risk of an unintended gift tax consequence? There are a number of options that you might consider for any 2021 gifts given this uncertainty. You could make a gift to a martial-type trust (QTIP-like trust) if you are married and make a QTIP election on the gift tax return reporting that gift. That would avoid a taxable gift. You could, for example, make a marital QTIP election for $10.7 million of the gift leaving the $1 million taxable gift to be offset by your new reduced exemption. If your estate is large enough for you and your spouse to each do this type of $11.7 million transfer you have another issue to consider. If both spouses do this similar plan it could be problematic under the reciprocal trust doctrine. That doctrine could “uncross” two too similar trusts and unravel the plan. So, this approach might be safer if used by only one spouse to transfer $11.7 million.
Make a Formula Gift: Another approach to use is to make a gift to a trust using a formula. The transfer documentation transferring assets to the trust could gift that fractional share of the asset the numerator of which is your available gift tax exemption, and the denominator of which is the full value of the gift as finally determined for gift tax purposes. You could contribute assets into a limited liability company (“LLC”) and make a transfer of a fractional interest in the LLC to the trust. The Numerator should consider the possibility of retroactive changes in exemption amount. So, it might be worded to be your gift tax exemption, reflecting a retroactive tax law change, if any. This concept is based in part on the Wandry case which respected a formula gift. Wandry v. Commissioner, T.C. Memo 2012-88. Also, be certain to use appropriate language in the formula “as finally determined for federal estate and gift tax purposes.” In the Nelson case the taxpayer did not use the appropriate terminology and lost. Nelson v. Commissioner, T.C. Memo 2020-81. Also, consider how to tailor this type of formula clause. What if the GST tax exemption is different then the gift tax exemption? Do you need to have different formula clauses for each tax? If you are gifting a group of assets, you should also consider ordering. Which gift should exemption be allocated to and which should it not be allocated to? A prioritization of allocations might be advisable to include in such instances.
Disclaimer Strategy: There is yet another approach you might consider in planning 2021 gifts to perhaps address the risk of a retroactive tax change. If you make the gift transfer of assets into a family trust and provide in that trust instrument that your spouse (for example) shall be treated as the principal beneficiary of the trust. And if your spouse disclaims (renounces) all his or her interest in the trust, and to the extent the spouse disclaims it does not move down to other beneficiaries as if the spouse died (the typical result of a disclaimer), but rather the asset reverts back to you as the donor. This might avoid an inadvertent gift tax if there is a retroactive change in exemption amounts. You might you are your spouse disclaim to the extent the transfer exceeds the exemption amount if the exemption amount is changed. That disclaimer must be filed before the end of nine months. Be certain spouse does not accept any benefit from the trust before exercising the disclaimer. Disclaimers are governed by Code Section 2518.
Rates: Consider that under Sanders tax proposal estate tax rates were to increase. So, higher estate, gift and GST rates may be a possibility.
Discounts: When an asset is valued for gift and estate tax purposes, the value may be reduced if you transfer (for gift tax purposes) of if you own (for estate tax purposes) a non-controlling interest in an entity. For example, if you own 25% of a family business worth $10 million, your 25% might be valued at less than the pro-rata $2.5 million because you have no ability to control the enterprise, distributions, liquidation, etc. These so-called valuation discounts may be eliminated in Democratic tax legislation. So, it may be advisable to engage in transactions now to lock in discounts.
Example: If your spouse died and left you valuable assets in a marital trust (or outright) those assets may be taxed on your death. It might be advantageous to consummate transfers now, while discounts remain possible. You might consummate a sale from a marital trust (a “QTIP” trust) to lock in the low interest rate and discounts which may be eliminated. What should you consider on a sale from a QTIP trust to a non-grantor trust? What about Code Section 2519? This Code Section says if the surviving spouse relinquishes any of her income interests in a QTIP trust, she will be deemed to have made a gift of the entirety of the trust. Estate of Kite v. Comm’r, 2013 T.C. Memo. 43, 105 T.C.M. 1277, 2013 Tax Ct. Memo LEXIS 43. Instead, perhaps you should invade the trust and have the surviving spouse make the sale. That might be safer. But be certain that if you make a principal distribution the trust permits that. Consider bifurcating the QTIP. If the QTIP is divided into two QTIP trusts and only the portion holding the stock to be sold consummates the sale perhaps the second QTIP will be insulated from an IRS 2519 attack. Note, however, that the Kite case included rather extreme facts and how and to what extent it may be applied in lesser situations is not certain.
GRATs: Grantor retained annuity trusts (“GRATs”) are a technique in which you gift assets to a trust in exchange for an annuity. Any growth in the value of trust assets above the annuity amount can inure to your heirs (or preferably a trust for them) gift tax free. This technique may become extinct because they may require 25% of the transfer as a taxable gift which might make the technique impractical to use.
Generation Skipping Transfer (“GST”) Tax: The Democrats have discussed assessing a GST tax on long term trusts every 50 or 90 years. This proposal is not a revenue raiser for the government, but it is primarily a social objective of minimizing the concentration of wealth.
Annual Exclusions: There is a proposal to cap these at $20,000/donor. Presently it is $15,000 per donee.