By: Meghan E. McCulloch – Principal – Elville and Associates, P.C.
Talking about politics can sometimes be risky business. However, as is often said, elections have consequences and in the context of estate planning it is important to examine the Biden Adminstration’s effect on estates, trusts, and tax planning. After the outcome of the recent Senate run-off election in Georgia, we now know that we have a Democrat controlled White House and House and the Senate is split with Vice President Kamala Harris holding the tie-breaking vote. This certainly changes the analysis of what is to come and makes the likelihood of potentially dramatic changes in tax law a much greater possibility than if the White House and Congress were divided.
Interest rates are at historic lows. The Section 7520 rate for January 2021 is .6%, which is almost the lowest it has ever been. A second federal stimulus package was passed at the end of December 2020, providing $900 billion dollars of economic relief, including enhanced unemployment benefits and additional direct cash economic stimulus payments, additional Paycheck Protection Program (PPP) for loans to small businesses, grants for theaters and concert venues, as well as funding for schools and childcare. The economic relief package made major changes to tax laws and the IRS delayed tax filing season to February 12th to allow the IRS to do additional programming. As a result, the IRS will not accept or process any returns for the 2020 tax year until this time. President Biden has proposed another stimulus package with a $1.9 trillion dollar price tag, which was recently discussed at a White House meeting with governors. The proposal includes additional direct stimulus payments to individuals, enhanced unemployment benefits, an increase in the federal minimum wage to $15 an hour, aid to state and local governments, and funding for COVID vaccines and testing. While some are debating the necessity of further economic stimulus funding, the package and recommendation for additional funding has been supported by Jerome Powell, the current Chairman of the Federal Reserve, and Janet Yellen, who was recently confirmed as Treasury Secretary. It is too early to fully predict the Biden Administration’s effect on tax planning and exact changes in tax law that may occur, but it certainly can be expected that increases in income and estate taxes are likely to increase to provide revenue.
It is helpful to examine recent changes in tax law in order to glean an idea of what changes we may be able to expect, including the Biden Administration’s effect on estates, trusts, and tax planning. Let’s take a closer look at some of these changes.
The 2017 Tax Cuts and Jobs Act (TCJA)
The 2017 Tax Cuts and Jobs Act (TCJA), made several significant changes to individual, estate, and trust tax regulations. The law included reforms to itemized deductions and nearly doubled the standard deduction and child tax credit. In place of personal exemptions, the standard deduction was increased. In place of dependent exemptions, the child tax credit was increased, and a new $500 tax credit was created for dependents who are ineligible for the child tax credit. It also reduced statutory tax rates at almost all levels of taxable income and shifted the thresholds for several income tax brackets.
The TCJA retained the preferential tax rates on long-term capital gains and qualified dividends and the 3.8 percent net investment income tax (“NIIT”). The NIIT applies to interest, dividends, short- and long-term capital gains, rents and royalties, and passive business income. The TCJA separated the tax-rate thresholds for capital gains and dividend income from the tax brackets for ordinary income for taxpayers with higher incomes. The individual Alternative Minimum Tax (“AMT”) was retained, but the exemption levels and income threshold at which the AMT exemption phases out. This significantly reduces the number of taxpayers subject to the AMT.
Most notably in the context of estate planning, the TCJA doubled the federal estate tax exemption to $11.2 million for single individuals and $22.4 million for married couples and continued to index the exemption levels for inflation. The current exemption amount for 2021 is $11.7 million for single individuals and $23.4 million for married couples.
Further detailed discussion regarding the above changes and regulations can be found here.
Generation-Skipping Transfer Tax
The generation-skipping transfer (GST) tax is a separate tax that is levied when transfers are made to or for the benefit of someone two or more generations younger that the transferor (i.e. “skip-persons”). These transfers are taxed at a rate of 40%. Current law under the TCJA provides for a separate GST exemption of $11.7 million and GST exemptions historically mirror the estate and gift tax exemption.
All of the individual tax and estate tax provisions in the TCJA sunset at the end of 2025, with a few exceptions. The individual provisions were intentionally made to be temporary in order to limit the revenue cost of the TCJA to a level consistent with the overall constraint on the 10-year revenue loss in the Congressional Budget Resolution and to comply with Senate budget rules used to pass the tax act that require no increase in the federal budget deficit after the tenth year.
Potential Tax Increases and Lower Exemption Amounts
With the new Democrat control of the White House and Congress, as a result of the Biden Administration’s effect on tax planning we should expect potentially significant tax increases on the wealthy, including income and estate taxes. Further, in light of the financial impact of the COVID-19 crisis, we can expect proposed changes to policy needed to pay for increased federal economic relief spending. While no specific policy has been proposed yet, during the campaign Biden suggested that he would support legislation that would reduce both the estate and GST exemptions to $3.5 million per individual and would support lowering the lifetime gift tax exemption to $1 million. The Biden Administration’s effect on tax planning is yet to be fully realized, but with time will come more into focus.
Loss of Discounts
Another possible tax change to expect is the loss of discounts. Under current law, individuals are able to enjoy the use of valuation discounts when transferring interests in closely held businesses through a lack of control discount and a lack of marketability discount. During the Obama administration, the Treasury released proposed regulations that would dramatically restrict the use of these valuation discounts, but the proposed regulations were withdrawn under the Trump administration. Renewed restrictions on the use of these discounts may be seen in future as part of any proposed changes to tax law.
Possible Phase Out of Deductions
The phase out of deductions is also a possibility. The Biden tax plan would phase out the “qualified business income” deduction under Code Section 199A for individuals with taxable income above $400,000.00. It would also cap the tax benefit of itemized deductions at 28% of the amount of the deduction for individuals earning more than $400,000.00 and reduce the value of itemized deductions by 3% of the amount by which a taxpayer’s adjusted gross income exceeds $400,000.00. Additional potential deductions that may be eliminated include those for contributions to IRAs, 401(k)s, and 403(b)s, and replace them with a new tax credit equal to a specified percentage of the amount contributed, which is currently expected to be 26%.
Possible Changes in Capital Gains
Another possibility may include dramatic changes in capital gains. Under current law, capital gains are taxed as regular income if the gains are realized on property held for less than one year. For long-term capital gains, i.e. gains on property held for a year or longer, there is a graduated tax rate depending upon the filer’s personal income level. For individuals who earn more than $200,000.00 and couples who earn more than $250,000.00 in net investment income annually, there is an additional 3.8 percent surtax added to their capital gains tax rate.
Current law also allows for like-kind exchanges on appreciated property like artwork and rental properties. This allows for the reinvestment of any gains earned on appreciated property into similar types of property within one hundred and eighty (180) days of the original sale and avoiding capital gains tax upon the sale of the property. If the individual continues to make like-kind exchanges on appreciated property until the individual’s death any capital gains accumulated in the property will be wiped out by the basis step-up rules.
The Biden Administration’s effect on tax planning and Biden tax plan proposes eliminating like-kind exchanges and imposing a 39.6 percent long-term capital gains tax rate on individuals earning more than $1 million per year in order to generate revenue to pay for child-care and elderly care initiatives. The Biden Administration’s effect on tax planning is reflective of an overall increase in the graduated income tax rates to restore the rates to their pre-2018 levels. If the 3.8 percent surtax on net investment income remains in place, the effective federal tax rate on long-term capital gains could exceed 43 percent.
While Biden has not specifically discussed capital gains with regard to estates and trusts with high income levels, it is likely that these ordinary rates for long-term capital gains will apply to estates and trusts with $1 million of annual income. These proposals may even affect estates and trusts at a lower income threshold, as estates and trusts under current law reach the highest marginal rate of income taxes at a much lower threshold of income that individual taxpayers.
Potential Elimination of the Step-Up Basis Rule for Inherited Property
A dramatic change related to the Biden Administration’s effect on estates and trusts could include the elimination of the step-up basis rule for inherited property. Further imposing a carryover basis rule for inherited property or the imposition of recognition of gain on property at the owner’s death. The step-up in basis of assets included in an estate has been a prominent principle in structuring estate plans since the carryover basis rule was repealed retroactively to 1976 in 1980. Current law allows for each asset to receive a step-up in basis of appreciated property at the death of the owner. This allows for inherited property to be sold or liquidated shortly after the owner’s death to minimize or eliminate any capital gain on the sale of the property so the decedent’s heirs incur capital gains only to the extent the asset has appreciated since the decedent’s death. Further, any capital gains that are considered “long-term,” meaning gains that the seller has owned for more than one year, are taxed at preferential rates.
A current tax planning strategy is to gift high-basis assets during the donor’s lifetime, since the donee receives the donor’s basis in the asset. This is the “carryover basis.” Donors should retain low-basis assets so that their heirs can receive those assets at death was a new stepped-up basis to the fair market value at the decedent’s date of death. The heirs can then sell the assets post-death without incurring significant capital gains tax that they would otherwise incur if they were to inherit the donor’s carryover basis.
The step-up in basis has served as a counterbalance to estate tax. If the fair market value of a decedent’s assets exceeds the estate tax exemption amount, estate tax is due on the excess amount, at a rate of 40%. However, little or no capital gains tax may be due as a result of the death, since the heirs inherit the assets with the stepped-up basis.
Biden has proposed repealing the concept of the stepped-up basis. One proposal is to eliminate the step up in basis such that a decedent’s heirs would inherit the carryover basis of an asset which could potentially result in an asset being subject to both estate and capital gains tax. The Biden Administration’s effect on estates and trusts may include possible proposals such as no step-up in basis for assets and death and realization of capital gains tax on assets at death. The first proposal would result in heirs owing capital gains on any appreciation between the donor’s original basis at acquisition and the value at the date of sale. Under the second proposal, an estate would owe capital gains on the appreciation accrued between the donor’s date of acquisition and the date of death and heirs would owe further capital gains tax on any appreciation between date of death and date of sale.
If any of these policies are enacted, an important question will be whether the changes will be applied retroactively. Typically, tax legislation is prospective, but changes enacted under the Biden Plan could be made retroactively effective to January 1, 2021 if such a law is enacted in 2021. However, in order for the Biden Administration’s effect on estates, trusts, and tax planning to be effective retroactively, the retroactivity of the law must be rationally related to a legitimate legislative purpose.
Now that we have examined the Biden Administration’s effect on estates, trusts, and tax planning and potential changes that may be coming down the line, what can we do to plan for them? At the most basic level, individuals who are worried about potential estate tax implications who did not complete or update their planning in 2020 should consult with their attorney about using their gift and GST exemptions before any chances in tax law are made. For the right clients under certain circumstances, other options may include grantor retained annuity trusts (“GRATs”), spousal lifetime access trusts (“SLATs”), charitable remainder or charitable remainder annuity trusts (“CRTs” or “CRATs”), and Roth conversions. If you are concerned about how any of these potential changes could impact your estate plan, it is important to review your assets and planning goals and develop an individualized plan that meets your needs and addresses your concerns. We cannot be sure of the changes in tax law and the Biden Administration’s effect on estates, trusts, and tax planning that will be coming over the next few years, but with effective planning, we can seek to minimize the tax consequences for our clients.
Ms. Meghan McCulloch, a principal with Elville and Associates, handles claims for Social Security disability benefits, Supplemental Security Income (SSI), childhood SSI benefits, and disabled widow and widower benefits at every level of appeal, from the initial application up to and including representation before the U.S. District Court of Maryland. She has a wealth of experience in addressing the unique needs of individuals and families as they navigate through the disability process. She also focuses her practice in the areas of special needs planning, elder law, estate planning, and is the leader of the firm’s estate and trust administration department.
Meghan is a member of the Maryland Volunteer Lawyers Service as well as an Executive Board Member of the Disability Section of the Maryland Association for Justice. She has also been named to the Rising Stars list by Maryland Super Lawyers the past six years.