As we are writing this article, the voting for the 2020 Presidential and Senate races is over, but the results are uncertain. Because Joe Biden currently appears to have won the race for President, we are going to assume in the discussion that follows that he has won. The battles for Senate seats seem that they will result, at most, in very tenuous control, and it is unclear which party will have that tenuous control. Two run-off elections in Georgia for Senate seats should determine which party is positioned to control. Quite possibly, the vote of just one Senator who sides with the opposition party on a given matter will shift the outcome of a vote.
We would like to communicate to you what we believe our nation can expect in federal tax law changes, but the election results, as uncertain as they are currently, make that effort quite a challenge. So, the Q&A which follows will try to inform you about the Biden proposals that surfaced during the campaign. As we do this, we remind you of something we all know, but sometimes overlook: Congress enacts laws, not the President. If Biden wins and the Republicans wind-up controlling the Senate (and don’t have any defections), it seems to us that no one can predict with much confidence what may happen with federal tax policy. We also note that often what candidates propose before they are elected is not what they strongly push after they are elected.
Personal Income Tax
1. Mr. Biden has been very clear in proposing increases in income taxes for high-income taxpayers. What has he proposed in the case of personal income taxes?
Mr. Biden has proposed increasing taxes on high-income Americans and rolling back certain provisions of the Tax Cuts and Jobs Act (“TCJA”), signed by President Trump at the end of 2017. Specifically, Mr. Biden has proposed these most significant changes:
- Raising taxes on individuals with taxable income above $400,000 by reverting the top individual income tax rate from 37% under current law to 39.6%;
- Taxing long-term capital gains and qualifying dividends at the ordinary income tax rate of 39.6% on taxable income exceeding $1,000,000;
- Limiting itemized deductions by restoring the Pease limitation (which reduced the amount that otherwise would be deductible by 3% of income exceeding a specified threshold) and imposing a 28% cap on the tax benefit of itemized deductions for taxpayers earning more than $400,000; and
- Phasing out the 20% qualified business income (“QBI”) deduction, enacted as part of the TCJA, for taxpayers with taxable income of more than $400,000.
2. The TCJA did not just reduce tax rates, it also reduced itemized deductions, such as limiting the deduction for state and local taxes, reducing the limit of home mortgage debt the interest on which is deductible, and eliminating miscellaneous deductions for such items as investment and tax compliance expenses. Does Mr. Biden propose to restore those deductions?
Mr. Biden has proposed removing the limit on the deduction for state and local taxes. Individual taxpayers are allowed an itemized deduction for state and local real and personal property and income taxes. Taxpayers may elect to deduct state and local general sales taxes instead of income taxes. The TCJA limited the aggregate deduction for state and local taxes to $10,000 for 2018 through 2025.
Besides removing the SALT cap, we have seen no mention in Mr. Biden’s proposals of restoring other itemized deductions that were reduced by the TCJA.
3. For a personal income tax return with taxable income exceeding $400,000, what would be the marginal federal income tax rate?
Under Mr. Biden’s proposals, the answer to this question is complicated. On the surface, the marginal rate would be merely the top tax rates, 39.6% on ordinary income and 20% on most capital gains and dividends. But, if taxable income exceeds $1,000,000, the marginal rate applicable on most capital gains and dividends also would go to 39.6%, presumably on the excess over $1,000,000. For example, consider someone who has $1,200,000 of taxable income, including $400,000 otherwise qualifying for the capital gain rate. We presume the ordinary income rate of 39.6% would apply only to the $200,000 excess of taxable income exceeding $1,000,000, not to the full $400,000. These kind of details are unknowable currently.
But, there’s more to the answer. Restoration of the Pease amendment would raise the marginal rate by as much as 1.2%. And, the 3.8% tax which has been in place since 2013 on net investment income (“the NIIT”) would apply at these levels of income. So, the marginal rate, federal only, could approach 45%, depending on the type of income.
And, the marginal rate could go even higher for someone who would otherwise qualify for the QBI deduction, but would lose it as taxable income gets above $400,000.
4. For those personal income tax returns with not more than $400,000 of taxable income, what are some of the more significant of Mr. Biden’s proposals?
Mr. Biden has proposed several tax changes advertised as being intended to benefit middle-income taxpayers. He has proposed a temporary increase in the child tax credit, set to expire after the economy recovers. Currently, taxpayers may claim a non-refundable child tax credit of $2,000 per child up to age sixteen. Mr. Biden would change this to a refundable credit of $3,600 per child up to age six and $3,000 per child for children ages seven to seventeen. Refundable credits can result in refunds to taxpayers even if they do not have any tax liability, in effect, making them welfare payments.
He has also proposed a $15,000 tax credit for first-time homebuyers, as well as a credit to ensure rent and utility bills do not exceed 30% of a taxpayer’s monthly income.
Mr. Biden has introduced other proposals targeted to middle-income taxpayers, but these may be the most significant.
5. From a taxpayer perspective, who are some “winners” and “losers” if Mr. Biden’s proposals become law?
If Mr. Biden’s proposals become law, high-income taxpayers are the clear losers. They face reduced deductions and higher rates. Owners of successful businesses which operate through pass-through entities like partnerships and S corporations or single member LLCs may lose the benefit of the QBI deduction.
By contrast, some middle and low-income taxpayers, especially families with children and first-time homebuyers, are the winners, as they are likely to see their after-tax income increase as the result of new and enhanced tax credits.
6. Do any of Mr. Biden’s proposals regarding estates affect personal income taxes?
Yes. One of Mr. Biden’s proposals involves eliminating the “stepped-up” basis rule that allows individuals who inherit property to receive a basis equal to the property’s fair market value at the time of the decedent’s death. This often allows individuals to sell inherited assets with little to no taxable gain. For example, suppose you inherit a property worth $500,000, and the decedent’s basis was $100,000. Although the property has $400,000 of built-in gain, under current law you would not be taxed on any of that gain if you sold it for $500,000. Mr. Biden’s proposal would change this rule, which could result in many more individuals owing capital gains tax on inherited assets.
Notably, the “stepped-up” basis rule was briefly eliminated in the past but reversed soon after, in part due to the administrative difficulty of determining the cost basis of all inherited assets. Similar challenges are likely to arise again if Mr. Biden is successful in changing the basis rules for inherited property.
7. At the current time, what are some tax saving planning ideas personal taxpayers might consider?
As we noted in the introduction to this article, the uncertainty surrounding the election results makes predicting future tax changes, and corresponding tax planning, quite difficult. The situation in the Senate may alleviate some of the urgency taxpayers would have felt if the Democrats had gained clear control of the Senate.
With the possibility of higher tax rates on the horizon, taxpayers might consider ways to accelerate income and capital gains into the current year to gain some certainty about the tax rates that will apply. Of course, if tax rates do increase, it is not possible to predict the effective date of those changes. Some economists believe higher tax rates could make economic recovery more difficult as the nation emerges from the pandemic; therefore, it is possible that tax increases, if they happen, could be further down the road. In our current state of uncertainty, the wisest advice for many taxpayers may be to stay the course.
Business Income Tax
1. What are the major changes Mr. Biden has proposed regarding business taxes?
Mr. Biden has proposed increasing the income tax rate on C corporations from 21% to 28%. In addition, he has proposed a 15% minimum tax on C corporations with book (financial statement) profits of $100 million or more. This would be structured as an alternative minimum tax, with corporations paying the regular corporate income tax or the 15% minimum tax, whichever is greater.
Other parts of Mr. Biden’s proposal target U.S. businesses that offshore profits by moving operations overseas. U.S. corporations with foreign subsidiaries could see taxes increase under Mr. Biden’s plan.
Finally, although he has not released many details, Mr. Biden has proposed a handful of business tax credits, including credits for manufacturers and for small businesses adopting workplace retirement savings plans. He also supports expanding several tax credits related to renewable energy.
2. How does Mr. Biden’s proposed tax rate on corporations compare to the rates in effect prior to the 2017 Tax Cuts and Jobs Act?
Before the TCJA, C corporations were subject to tax at different rates as taxable income increased, eventually reaching a flat 35% rate on all taxable income. The TCJA reduced this to a flat 21%. Mr. Biden has proposed increasing the rate to a flat 28%.
3. Would the changes proposed by Mr. Biden, if enacted, likely impact the decision of closely-held businesses about the type of tax entity to select?
Businesses are taxed on their income at the business entity level (C corporations) or at the owner level (individuals, estates, and certain trusts). Both tax and non-tax considerations factor into the choice of entity determination.
Income earned by C corporations generally is subject double taxation. That is, C corporations pay entity-level tax on their income, and the income is taxed again when it is realized by shareholders in the forms of dividends, stock sales, and corporate liquidations. By contrast, income earned by flow-through entities generally is taxed only once—when it passes through to the entity’s ultimate tax-paying owners. Although C corporations often are viewed as less efficient from a tax perspective, the drop in the corporate income tax rate under the TCJA made doing business in the corporate form somewhat more desirable than before.
If Mr. Biden is successful in raising the corporate income tax rate by 7% and taking away the capital gain rates for business owners with taxable income exceeding $1,000,000, there are fewer tax advantages to operating as a C corporation. Another relevant factor is Mr. Biden’s proposal to phase out the 20% QBI deduction for owners with taxable income above $400,000. If this change is enacted, some owners of flow-through entities will experience higher taxes.
Back to the question, the decision of what type of tax entity a business should select would remain very dependent on the specific situations, expectations, and motivations of the businesses and their owners. There clearly is no one-size-all that fits every situation. We suspect that most closely-held business owners and their advisors will continue to avoid C corporation tax status, if they are not already C corporations.
4. Is it correct that Mr. Biden has proposed eliminating “like-kind” exchanges?
Yes, Mr. Biden has proposed eliminating “like-kind” exchanges, sometimes called “1031” exchanges, a reference to Internal Revenue Code Section 1031. These rules allow owners of real property used for business or held as an investment to exchange that property for other property of “like-kind” (i.e., “replacement property”) without recognizing gain. If the 1031 requirements are satisfied, the property owner can defer recognizing gain until the replacement property is sold (absent another like-kind exchange at that time).
Prior to the enactment of the TCJA, the like-kind exchange rules applied to both real property and personal property, such as business machinery, equipment, and vehicles. The TCJA eliminated like-kind exchanges for personal property, but preserved like-kind exchange treatment for real property.
Estate, Gift, and Generation-Skipping Transfer Taxes
1. What are the main elements of Mr. Biden’s proposals relating to these transfer taxes?
Mr. Biden’s proposals, if enacted, would reduce the amount that is exempt from these transfer taxes and raise the tax rate from 40% to 45%. For 2020, the gift and estate tax exclusion is $11.58 million per person ($23.16 million per married couple), and these amounts increase to $11.7 million and $23.4 million, respectively, for 2021. An individual can make taxable transfers with a cumulative value up to this amount either through lifetime gifts or at death without triggering transfer tax liability. Gifts which qualify for the annual per donee exclusion of $15,000, as well as certain gifts to pay tuition and medical expenses, do not count against the exemption.
The TCJA temporarily increased the gift and estate tax exemption from $5 million to $10 million, adjusted for inflation, for 2018 through 2025. In 2026, the exemption is scheduled to revert to an inflation-adjusted $5 million. Mr. Biden has proposed reducing the exclusion amount even further, to its 2009 level of $3.5 million.
2. Under the heading of Personal Income Tax changes, you mentioned the proposal to eliminate “stepped-up basis” for estate beneficiaries. How will this change how estate assets are distributed between or among multiple estate beneficiaries?
As discussed earlier, Mr. Biden has proposed eliminating the “stepped-up basis” rule that allows individuals who inherit property to receive a basis equal to the property’s fair market value at the date of death. With the elimination of this rule, individuals who inherit appreciated assets could face significant taxes when those assets are sold.
If Mr. Biden’s proposal is enacted, it may change how individuals plan to distribute assets to different beneficiaries. For example, if Asset A, which has substantial appreciation, is to go to one beneficiary and Asset B, which has the same value but little or no appreciation, is to go to another beneficiary, the two beneficiaries are not getting the same net of tax value. For estates with documents not providing directions for dealing with unrealized appreciation, administrators presumably would need to fairly balance the amount of unrealized gain passing to multiple beneficiaries.
3. How are Mr. Biden’s proposals, if enacted, likely to impact estate planning in the future?
Obviously, the lower exemptions and higher rates he proposes would cause many more people to take transfer taxes into consideration in their planning, and they would motivate higher levels of lifetime gifts.
Elimination of the “stepped-up basis rule” would have a major impact on estate planning. Many individuals now go to great lengths to avoid recognizing gain from the sale of assets toward the end of their lives, because they can leave those assets to beneficiaries and avoid tax on the built-in gain. Without stepped-up basis, individuals may instead seek to sell highly appreciated assets during life so the income tax paid on such sales would remove assets from taxable estates.
4. Are there any planning ideas that people should be considering now?
High net worth individuals who otherwise would have waited until 2025 to take advantage of high transfer tax exemptions might consider acting sooner to avoid an earlier than scheduled reduction in exemption amounts. An individual’s and the family’s specific circumstances will indicate which gift strategies are most appropriate.
In apparent anticipation of a reduced exemption already scheduled after 2025, the Treasury Department has already issued regulations which would not claw-back into taxable transfers those prior transfers which used exemption amounts exceeding future reduced amounts.
Other Federal Taxes
1. Are there other federal taxes Mr. Biden has proposed to change?
Yes, two seem worthy of noting. He has proposed increasing Social Security tax for those whose subject earnings exceed $400,000. For 2021, the maximum amount of earnings subject to Social Security tax is $142,800. Subject earnings above that are subject to Medicare tax, but not to Social Security tax. Mr. Biden’s proposal would extend the Social Security tax to subject earnings above $400,000.
Though no specifics are available, Mr. Biden has expressed support for a financial transactions tax, presumably applicable to purchases and sales of securities.