Financial Planning Now In Anticipation of the Upcoming Election
With inauguration day less than six months away, taxpayers are still adjusting their organizational structures and transactions to address the ongoing COVID-19 pandemic and an economy still reeling from the resulting recession. With the increasing political polarization and economic uncertainty in mind, tax policy will be critical point of differentiation in the 2020 presidential race and have important ramifications on your financial wellbeing.
Of course, even if Democrats control both the White House and Congress, there is no guarantee that any of these proposals presented to date will be adopted. But most experts can agree that current tax rates for both individuals and corporations are at a historically low point, and some low rates are already scheduled to sunset after 2025. Higher taxes therefore appear inevitable, due to fiscal pressure to generate revenue to pay for the over $3 trillion in current COVID-19 relief measures with a fourth stimulus package currently being negotiated.
This alert sets out to highlight some of the election’s potential tax implications should President Trump win, or if former Vice President Biden should win and Democrats should acquire control of Congress. A Biden administration would rollback many of the 2017 tax cuts and would increase capital gains and payroll taxes on high-earners. A Trump administration would look to make the 2017 tax cuts permanent and would propose to reduce the long-term capital gains tax rates through indexing. We have developed a summary of the more significant income tax changes Biden has proposed and how it compares to Trump’s plan.
From a corporate perspective, the largest source of new business revenue from the Biden proposal is an increase in the corporate tax rate from 21% to 28%. (Vice presidential candidate Senator Kamala Harris went further during her presidential campaign, proposing a 35% corporate tax rate.) Biden’s plan would also raise an additional $470 billion from an increase in tax on foreign profits and create a new alternative minimum tax of 15% on global book income, while still allowing net operating losses and foreign tax credits, for corporations with more than $100 million in book net income. For companies operating in the United States and abroad, Biden has also proposed doubling the tax rate on global intangible low-taxed income to 21% (currently 10.5%).
The proposed Biden 15% alternative minimum tax could adversely impact start-up companies and other corporations whose taxable income is likely to be materially lower than their book income, such as taxpayers with capital intensive projects, which would lose the benefits of tax bonus depreciation.
President Trump has been campaigning on making certain expiring provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) permanent, including the 20% tax deduction for pass-through entities. (Biden would phase out the 20% pass-through deduction for income over $400,000.) Expect additional proposals to be put forth closer to the election.
Planning: With both potential rising tax rates and a new corporate alternative minimum tax, income acceleration techniques and capital improvement projects should be considered. Rising corporate rates will also prompt many businesses to revisit their business entity structure to determine whether a partnership or LLC is more advantageous than a C corporation.
For most individuals, the most impactful proposed Biden changes are to the tax rates, which would return the current 37% top rate to the 39.6% pre-TCJA level for taxpayers with incomes above $400,000. In addition, Biden would limit total itemized deductions to where the reduction in tax liability per dollar of deduction does not exceed 28%, meaning taxpayers in tax brackets higher than 28% will face limited itemized deductions.
Trump proposes a 10% middle-class tax cut, which reportedly could include lowering the 22% marginal tax rate to 15%. For 2020, the 22% marginal tax rate 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 is scheduled to expire after 2025.
Planning: A lower-income-tax-rate environment is generally favorable for Roth IRA conversions to lock in lower tax rates on pretax retirement savings. Income acceleration strategies, such as capital gain harvesting, and deduction deferrals would be recommended options should tax rates be expected to rise in the future. While uncertain at this point, should the Biden plan restore the state and local tax deduction for amounts above the current $10,000 cap, itemizers should also plan to defer payments of these taxes to after the law change.
Investment Income and Capital Gains
Under the Biden plan, the tax rate on long-term capital gains and dividends would be increased from 20% to 39.6% for taxpayers with income above $1 million. This income would continue to be subject to the 3.8% net investment income tax as it was enacted as part of the Affordable Care Act. The impact of this would be significant 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 now, before any rate increase comes into effect.
Biden supports a financial transaction tax on trades of stocks, bonds and other financial instruments but has not released the details of this plan. Vice presidential candidate Senator Kamal 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.
President Trump said on August 10th that he’s “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-identified period.
Planning: Expect many people with incomes over $1 million to sell appreciated assets prior to the elimination of the 20% preferential rate for long-term capital gains and qualified dividends. Another effective capital gains tax mitigation strategy is the gifting of 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 an effective way to sidestep the capital gains tax on disposition. Another strategy, the reinvestment of realized capital gains in to qualified opportunity zone funds, should be considered but also carries some risk. The benefits include the ability to defer a current capital gain to 2026, avoid 10% of that current capital gain if it is held for 5 years, and permanently avoid all future capital gains after the contribution if held for 10 years or more. The risk however is that the current deferred to 2026 capital gain is subject to whatever capital tax rate is in effect in 2026, which could be a substantially higher rate than today.
Biden seeks to eliminate the Social Security tax exemption for wages and self-employment earnings above $400,000, and therefore, wages and earnings between $137,700 and $400,000 would not be taxed, creating a donut-hole structure. Because the 12.4% Social Security tax is split evenly between the employer and the employee, this proposal would increase payroll taxes for both high-income wage earners and their employers.
Trump, facing an impasse on Capitol Hill over coronavirus relief, issued an executive directive on August 8th that would 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: One possible solution for business owners should the Social Security tax be expanded is to convert to an S-corporation structure. S-corporation dividends are not subject to employment taxes. In the executive compensation area, incentive stock options would become more popular because there is no Social Security tax on the option spread.
Estate & Gift Taxes
The current estate tax exemption threshold is $11.58 million per individual (indexed for inflation) with a top tax rate of 40%. This amount is scheduled to revert to the pre-TCJA 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”. This could mean restoring the exemption threshold to the 2009 level of $3.5 million per individual, and it could portend an estate tax rate increase back to the 45% rate in effect in 2009, or even higher.
The Trump plan would extend the higher estate and gift tax exemption enacted by the TCJA that is scheduled to expire after 2025. Assuming the Trump plan is not enacted and/or in anticipation of enactment of a Biden-Sanders plan, taxpayers with more than the full $11.58 exclusion amount should be planning gifts of their full exclusion amount NOW, before the exclusion amount might revert to a lower threshold.
Planning: In 2019, the Treasury finalized taxpayer friendly regulations confirming that this temporary increased estate and gift tax exemption will not be clawed back for taxpayers who die after 2025. However, the Treasury rejected so-called “off the top” use of exemption, meaning that the benefit of the increased exclusion amount is a use-it-or-lose-it proposition, encouraging taxpayers to act now to use the current increased exemption before the law changes under a new administration or reverts back 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.
Likely the 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.
Planning: With 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, the Biden proposal would create significant practical problems in establishing the tax basis of long-held assets such as family businesses or farms, or investment assets for which the historical tax basis is no longer available. Taxpayers with significant appreciated assets should carefully consider a wealth-transfer plan prior to enactment of such proposals.
Elimination of Tax Benefit for Real Estate Like-Kind Exchanges
The TCJA repealed 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 like-kind exchange treatment for real property for taxpayers with income over $400,000.
Planning: Taxpayers with real estate contemplating a Section 1031 like-kind exchange should complete their transactions to defer their tax gains prior to enactment of such a provision.
Biden vs. Trump Comparison Chart
The results of an election are impossible to predict, as 2016 has shown. Which of these proposals become law depends not just on the Presidential election, but on which party controls the Senate. Should Democrats win the White House as well as the House and Senate, the enactment of tax changes in 2021 is highly likely. Sweeping tax changes such as those proposed are not typically retroactive and therefore might not be effective until January 1, 2022 once passes. However, it is possible these tax increases could be retroactive to as soon as January 1, 2021.
It is critical for investors to consider these proposed law changes in their current investment and estate planning. If you have any questions on how this may impact you, please do not hesitate to contact your Wintrust Wealth Services advisor.
Illinois CPA Society member Daniel F. Rahill, CPA, JD, LL.M., CGMA, is a managing director at Wintrust Wealth Services. He is also a former chair of the Illinois CPA Society Board of Directors.
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; professional tax and legal advice should always be obtained. Securities, insurance products, financial planning, and investment management services are offered through Wintrust Investments, LLC (Member FINRA/SIPC), founded in 1931. Trust and asset management services offered by The Chicago Trust Company, N.A. and Great Lakes Advisors, LLC, respectively. © 2020 Wintrust Wealth Management Investment products such as stocks, bonds, and mutual funds are: NOT FDIC INSURED | NOT BANK GUARANTEED | MAY LOSE VALUE | NOT A DEPOSIT | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY