Significant Proposed Tax Law Changes in Light of the "Build Back Better Act"
November 2, 2021
By now, we are sure that you are aware of the considerable discussion in the media about Congress wanting to in large part revise a number of favorable tax laws. Congress has recently taken steps to make changes a reality through a new and pressing series of proposed tax law changes with the “Build Back Better Act” (the “Act”) that is making its way through the legislative process in Washington, D.C. New tax laws might be enacted, if at all, as early as mid-November but possibly by late December.
This letter is GCT’s Tax & Trust & Estates Practice Group effort to offer some ideas as to what actions you may consider to support you reaching your tax planning and estate planning goals no matter what Congress ultimately does, or does not, do. It is crucial to note, these tax law changes may not become part of the final bill or may change over the next few weeks or months. Initially, we have included an overview of what the House has proposed so far, and what it has not. We have also included a potential list of tax planning steps that you might consider taking before any law may be enacted, by December 31st of this year and at some point in the near future. This letter is intended to provide a general overview and discussion only and you are encouraged to consult with us and/or your other tax and financial advisors before taking any action.
Significant Proposed Tax Changes
On September 13, 2021, the House Ways and Means Committee released draft tax legislation intended to form a part of the Act, which if enacted, would significantly impact both current structures and future planning that you should be aware of and may wish to discuss with us as soon as possible. As noted, all of this proposed legislation remains subject to revision as it moves through the legislative process before a full vote.
The legislation provisions include these proposed changes to:
A. Individual Income Taxes - Generally
- Increase the top marginal ordinary income tax rate to 39.6% (from 37%) effective January 1, 2022, (for individuals, the income level at which the top rate takes effect is reduced to $450,000 for married individuals filing jointly and $400,000 for single taxpayers, and for estates and trusts, the level remains unchanged at $13,450) and the top long-term capital gains (“LTCG”) tax rate to 25% (from 20%) for individuals in the new 39.6% ordinary income bracket generally effective for any gain realized after September 13, 2021. As proposed, the LTCG rate hike would apply retroactively. The proposed effective date for the increased capital gains tax rate would be for transactions after September 13, 2021. The proposal also lays out a transition rule for 2021 requiring a separate accounting for gains and losses incurred before, on or after the September 13, 2021 effective date. The determination of when to account for pass-through gains and losses will be made at the entity level. In addition, the proposal includes a “safe harbor” provision for written binding contracts made on or before September 13, 2021.
- Impose a 3% surtax on taxpayers with modified adjusted gross income above $5 million ($2.5 million for married filing separately). It is noted that, estates and trusts only have an income threshold of $100,000 before the surtax applies. [At the recent White House press conference addressing the revised Act framework, apply a 5% rate above income of $10 million, and an additional 3% percent surtax on income above $25 million. The framework will also close the loopholes that allows some taxpayers to avoid paying the 3.8% Medicare tax on their earnings].
- Increase the holding period for capital gains treatment for carried interests to five years (from three), with exceptions for real estate.
- Subject digital assets (including cryptocurrencies), commodities and foreign currency to expanded constructive and wash-sale rules that suspend losses taken only when a taxpayer buys a "substantially identical" security within 30 days of taking the loss.
- Prohibit additional contributions to traditional IRAs with account balances in excess of $10 million, and increase required minimum distributions from large IRAs, both traditional and Roth.
Prohibit IRAs from investing in assets available only to accredited investors (such as many alternative investment funds).
B. Individual Income Taxes for Business Owners
- Subject all profits from businesses to the 3.8% net investment income tax, which currently is only applicable to interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer.
- Permanently disallow a deduction for business losses (those greater than business income) in excess of $500,000 (with minor exceptions).
- Limit the IRC Section 1202 qualified small business stock (QSBS) exclusion to 50% (currently 100%) for taxpayers with income greater than $400,000.
- The deduction for qualified business income under 199A (the qualified business income deduction) will be capped at specified amounts, $500,000 for married filing jointly, $250,000 for married filing separate, $10,000 for estates and trusts and $400,000 for all other taxpayers. The current phase-outs of the deduction would remain the same.
C. Gift and Estate Taxes
- Reduce the gift and estate tax exclusion amount from $10 million (inflation-adjusted at $11.7 million currently) to $5 million (inflation-adjusted to $6 million) effective on January 1 2022, rather than January 1, 2026, the date when it’s currently scheduled under law, to drop down to that level.
- Change the treatment of grantor trusts under two entirely new provisions added to the Internal Revenue Code that would cause (i) all assets in a revocable or irrevocable grantor trust (IGT) that the person who is now deceased established after this new law is enacted and include it in that person’s estate, (ii) cause sales between an IGT and the grantor to be treated as sales to third parties triggering gain on appreciated property, (iii) cause exchanges of property between a grantor and an IGT to trigger gain on appreciated property, (iv) cause distributions from a grantor trust to anyone other than the grantor or the grantor’s spouse to be treated as gifts, and (v) cause a grantor trust’s ceasing to be a grantor trust to be treated as a gift by the grantor. These changes would greatly reduce all IGT transfer tax-effectiveness but should not negatively impact existing IGTs unless future contributions are made to them. These changes would be effective for trusts created on or after the date of enactment, and contributions after enactment for trusts that were created prior to the law. Grantor trusts created and funded before enactment would be unaffected. This provision has potentially far-reaching consequences that will impact the future of Grantor Retained Annuity Trusts (GRATs), Irrevocable Life Insurance Trusts (ILITs), Spousal Lifetime Access Trusts (SLATs), Intentionally Defective Grantor Trusts (IDGTs), Charitable Lead Annuity Trusts (CLATs) and other planning strategies.
- Valuation discounts are a means of leveraging the gift and estate tax exclusion and are commonly used with gifts of interests in entities such as limited liability companies and limited partnerships, outright or in trust. Under the Act, valuation discounts would be disallowed for nonbusiness assets held by an entity, i.e., passive assets held for the production of income but not actively used in the trade or business with limited exceptions for reasonable working capital and assets used in hedging transactions. There is also a look-through provision that applies if an entity holds at least a 10% interest in another entity. This change would be effective after the date of enactment of the Act (not the end of the year), which could be any time before the end of the year.
D. Corporate Income Taxes
- Increase the corporate income tax rate to 26.5% (from 21%).
Tax Law Changes Not Included in the Act
Most noteworthy, the Act does not currently contain:
- A potential repeal or increase of the cap on deductions for state and local taxes (SALT) paid. As suggested, it remains possible this will be added, as a number of House Democrats from high-tax states insist it is necessary to gain their support for any tax bill. Many expect that any bill that ultimately passes would at least double the currently $10K SALT deduction.
- Proposed elimination of the basis adjustment (step-up in basis) at death rule, which greatly impacts the amount of wealth a family can pass to the next generation.
- Any proposal to deem death a realization event, triggering a capital gain on any unrealized growth; or imposing some type of annual tax, on the appreciation of taxpayer wealth; or any changes to the generation-skipping transfer tax.
- Further limitations of the current scope of tax-advantaged 1031 like-kind exchanges.
Potential Tax Planning Items to Consider
When reviewing this letter, please be aware that it is unclear whether any new tax law will be enacted during this session of Congress and, if any is, what that law’s terms may be.
Still, there are some actions we think you may be well-advised to consider taking (a) before any bill is signed into law, (b) prior to January 1, 2022, and (c) at some time in the near term that are not tied to a specific date or event.
Again, we encourage you to speak with us, and other advisors, to determine which of these planning steps may be right for you and for your family. We also advise against letting “the tax tail wag the dog.” Any of your decisions should be made in the context of your particular goals.
A. Before New Tax Legislation is Enacted:
- Establish and fund IGTs, including SLATs, preferably dynasty trusts that can last in perpetuity up to the maximum amount that you can give during lifetime without having to pay gift tax (which is currently $11.7 million per person and $23.4 million for a married couple).
- Transfer assets whose value may be discounted from their apparent value (because they may be minority interests in illiquid asset) into irrevocable trusts, whether IGTs or “non-grantor” trusts.
- Consider whether the grantor trust status of existing IGTs may and should be “turned off,” typically by releasing grantor trust powers retained by the grantor.
B. Prior to January 1, 2022:
- Use up whatever is left of your lifetime exclusion of $11.7 million, no matter where you make those gifts (IGTs, funded prior to enactment, non-grantor trusts or outright to the recipient). The exclusion is already, under current law, scheduled to be reduced on January1, 2026, to approximately $6 million and the present legislative proposal will accelerate that reduction to January 1, 2022. You need to understand that the proposed changes may be modified before (and if) enacted.
- Accelerate income into 2021, particularly if your income is above $5 million, as your total rate increase might be 5.6% (2.6% for ordinary bracket plus 3% surtax). If you have retirement accounts, now may be a good time to consider a Roth conversion, so you might pay this year’s income tax rates on the converted assets and also, to avoid a potential imposition of the 3% surtax in 2022.
- Defer deductions including charitable deductions into 2022. A deduction’s economic value is higher when the taxpayer’s tax rate is higher. To be sure, deferring the deduction, or accelerating discretionary income, requires paying tax sooner on income, so you will need to weigh the economics of paying more tax now at a lower rate rather than recognizing more income in a future year at higher rates. If 2021 is a greater than normal income year for you or you are donating appreciated assets to charity, it may still be prudent to donate in 2021 even if rates increase next year.
- If feasible, divide a large non-grantor trust (with $5 million or more) that benefits multiple beneficiaries into smaller trusts, each for the benefit of a single beneficiary. The 3% surtax on high-income taxpayers is proposed to apply to trusts whose adjusted gross income (after deductions for distributions to beneficiaries) is greater than $100,000 (for individual taxpayers, as noted above, $5 million). As currently proposed, separate trusts (with separate tax identification numbers) will each be allowed $100,000 of income before the surtax is applicable.
- Take losses on the sale of cryptocurrencies and other property that starting in 2022 might be subject to the wash sale rule.
C. Additional Planning in the Near Term:
- Invest some available cash in a cash value life insurance policy. Assets invested by an insurance company on behalf of a policyholder appreciate free of income tax and are also generally protected from creditors’ claims. The benefits of this tax deferral feature increases when tax rates are higher.
- Analyze the tax classification of operating businesses, comparing pass-thru entities (such as partnerships or S corporations) to C corporate entities which considers both shareholder and entity level taxation under the current and proposed law changes to determine the most tax efficient classification within the context of your business structure. The differences to your ultimate bottom-line may be substantial since the proposed legislation provides that high-income taxpayers would not able to avail themselves of the 100% exclusion from capital gains tax of a significant portion of their QSBS potentially making the conversion to a pass-through entity more desirable.
Our final takeaway is that if enacted, the proposed changes discussed in this letter will have a material impact on the tax burden for high-income individuals as well as the estate and trust planning that has been previously done.
Please feel free to contact a member of GCT's Estate Planning & Taxation Group to schedule a time to visit and discuss the impact of these potential changes and possible planning techniques to minimize their impact.