President Biden has been talking about increasing taxes for wealthy Americans since he started running for office. He formally released his proposed changes as part of the American Families Plan in April of this year. As often happens in the U.S. legislation process, there were lots of negotiations and compromises behind the scenes. The Ways and Means Committee recently released their votable version of a 645-page bill, which has significant changes from President Biden’s original plan.
This has not yet been passed as legislation and there are likely to be more negotiations and compromises along the way, but because many of the rules are likely to pass, it is worth sharing the details and potential actions. Below you will find our take on the good, the bad, and the ugly.
It is never good when you pay more in taxes, but there are some details in the proposal that qualify as good, or at least better then expected.
As promised by President Biden, all tax increases won’t affect the majority of U.S. taxpayers. All the tax increases and disqualifications apply to individuals with income above $400,000 or married couples filing jointly with income above $450,000.
There are significant expansion or extension of tax credits including:
Rising tax rates don’t qualify as good, but capital gains tax is not nearly as high as originally proposed. More details on this later.
The bill does not eliminate the step-up cost basis for inherited assets.
While the proposed bill puts significant restriction on qualified retirement accounts, it would allow Roth conversions for another 10 years.
While the proposed rules do not affect tax filers under a certain threshold, there are changes that may have significant impact on taxpayers with income above $400,000. All proposed tax changes would be affective as of 1/1/2022 unless otherwise noted.
The bill would leave most tax rates and brackets in place but increase the top tax rate from 37% to 39.6%. The new rate has been used periodically since 1993, so this is nothing new. In fact, the current rate, which has been in place since 2018, was set to revert in 2026. The brackets for the new top rate would apply to individuals with income above $400,000, or married couples filing jointly with income above $450,000.
These brackets are not that different than the taxes under the Obama administration but are significantly different than those currently in place. The combination of higher rates, lower brackets, and less deductions can have a significant impact on tax dollars paid by families with income between $400,000 and $700,000.
President Biden’s initial proposal increased capital gains rates to 39.6% for those with income above $1M. This would have effectively doubled the tax on capital gains and qualified dividends for wealthy individuals. The proposed bill instead increases the highest capital gains rate from 20% to 25%. This new rate would apply once income is above $400,000 for individuals and $450,000 for married couples filing jointly. The standing net investment income (NII) tax of 3.8% applies to all capital gains and dividends so the effective rate on investments would be 28.8% going forward. The increased rate on capital gains would be retroactive, but would apply to any capital gains or qualified dividends received after September 13, 2021.
The proposed bill would increase taxes on businesses in three different ways.
C-Corps: The current flat tax of 21% would be replaced with a graduated structure with a lower rate of 18% on the first $400,000 of profits, followed by a 21% tax on income between $400,000 and $5M, and a maximum rate of 26.5% for income above $5M. The graduated rate would phase out for corporations with income above $10M.
Expansion of the 3.8% Net Investment Income Tax (NIIT): The NIIT would apply to income from S-Corps that is otherwise not subject to FICA tax when the recipient of the income has AGI above $400,000 for single filers and $500,000 for joint filers.
Limits on 199A Qualified Business Income Deduction: The Tax Cuts and Jobs Act (TCJA) included a complicated 20% deduction of taxable income for pass through businesses. Many businesses were excluded based on income thresholds and/or actual business definitions. The new proposal would limit the deductions to a maximum deduction of $400,000 for single filers, and $500,000 for joint filers. Business owners with profits below $2M ($2.5M for joint filers) will still get the full benefits of the QBI deduction.
As expected, many people try to maximize the opportunity of tax-free and tax-deferred IRAs. There are some examples (Peter Theil and Mitt Romney) of a few knocking the ball out of the park and creating fortunes of non-taxable money. This proposed law would put restrictions on IRA accounts for ultra-high net worth individuals, by limiting future contributions and requiring distributions from IRA accounts when assets are above $10M. (The required distributions would be 50% of the cumulative sum of retirement accounts over $10M and 100% of amount over $20M.)
3% Surtax on Income over $5M
Without naming it as a higher bracket, the proposal does create a new highest rate by adding a 3% surtax on any income over $5M. While this would only apply to a small group of very high-income tax filers, the maximum rate would effectively increase to 42.6% for those lucky few.
Things we never like to see in tax changes are increased complexity or the elimination of strategies that we’ve used effectively for clients. We consider that “the ugly” and unfortunately there is a bit of ugly in this bill.
It is one thing when you pay a bit more money when you file your taxes, but it’s completely different when things get more complicated, unfair, or existing strategies get undermined. We consider this “the ugly.”
The marriage penalty is defined as how much two working individuals would pay in tax if married compared to if they were single and filing separately. The problem is based on tax brackets for different filing statuses. This has been a historical tax issue but was pretty much eliminated under the TCJA in 2018. Unfortunately, the marriage penalty comes back significantly in these higher tax rates. For instance, if a married couple of two high-income earners ($300,000 each in salaried income) files jointly, $150,000 would be taxed at the highest rate or 39.6%. If they were not married and filing separately, neither would be taxed at the highest rate.
The restrictions on IRA accounts will essentially eliminate the Back Door Roth strategy, which has been very effective for some clients.
There are several other proposed limitations for retirement accounts. One impacts the ability to invest in a business that is owned or managed by the IRA beneficiary. The other would implement significant (and what we consider unreasonable) limitations on the type of funds and investments that could be owned within an IRA.
Advanced estate planning is like a chess game. There are lots of pieces on the board and based on each family’s goals, values, and money, you can implement a number of different strategies to achieve the best overall result.
One of the variables that is always under consideration is the lifetime exemption, which is the amount of money that can be gifted (while alive or at death) before an estate tax (currently 40%) is applied. The current exemption, which was increased under the TCJA in 2018, is roughly $12M per individual or $24M per couple. Like many other tax benefits in the TCJA, this was set to expire and revert to prior numbers (with inflation adjustments) in 2026. The proposed bill accelerates the expiration to 1/1/22. This would bring the lifetime exemption to roughly $6M per individual or $12M per couple.
When this threshold went up, it took the estate tax issue off the plate for many families. If it goes back down, then many families will need to revisit their estate plan and recalculate the potential estate tax. If the lifetime exemption is used before the expiration, there is no claw-back, so there are strategies that can be used to capture the larger amount before it goes away. Unfortunately, many of these opportunities, including gifts to a grantor trust, are likely to be disqualified when this legislation is passed, so it may require quick action for those who want to maximize the opportunity of the current lifetime exemption.
Trusts are often used as a vehicle to gift money either while alive or at death, and there are many advanced estate planning strategies that can be implemented via trusts. While the proposed law eliminates many of those strategies going forward, anything that is implemented and funded before the passing of the legislation would be grandfathered in.
While the tax rate increases have a relatively high threshold for individuals and families with high income, the same is not true for trusts. The highest capital gains rate and highest marginal rate applies once income in a trust is over roughly $13,000. The 3% surtax would also apply to all trust income once it passes $100,000.
Trusts are designed to be as tax efficient as possible. These changes will make that much harder going forward.
For more than 20 years, we’ve been implementing best practices and strategies to maximize tax efficiency for clients. While this is a proposal and not yet a law, it is worth reviewing in detail the potential impact and acting as needed.