INTRODUCTION
In a prior article, Charles J. Allen previously discussed the tax plans of the democratic presidential candidates, while Josh Sage discussed some of Biden’s potential changes here. With the Associated Press calling the presidential race for former vice president Joe Biden on November 7th, time is running short for many taxpayers to take advantage of existing tax benefits, such as those established under the 2017 Tax Cuts and Jobs Act (“TCJA”), as Biden plans to reverse many of them and implement several other changes as well.
INCOME TAX
Biden has made it pretty clear that income tax is a major focus of his tax reform plan. His main focus is on “wealthy individuals,” with special emphasis on individuals with taxable income of more than $400,000 a year.[1] Biden plans to revert the highest income tax rate, reduced to 37% under the TCJA, back to 39.6%.[2] He also plans to tax long-term capital gains (currently taxed at a maximum rate of 20%) at ordinary income rates for taxpayers who have taxable income of $1 million or more.[3] For taxpayers with more than $400,000 in taxable income, Biden plans to cap the benefit of itemized deductions to 28%, reenact the Pease limitation[4] for itemized deductions, and phase out the qualified business income deduction under Section 199A.
As a part of his promise to provide meaningful tax relief for working families, Biden plans to expand the Child Tax Credit, reestablish the First-Time Homebuyers’ Tax Credit, expand tax credits related to health insurance, and establish tax credits for older Americans who choose to buy long-term care insurance.[5] Additionally, his website states that Biden plans to equalize retirement benefits across the income scale, so working families also receive substantial tax benefits when they put money away for retirement.[6] Biden has also made statements suggesting he would like to expand the Low-Income Housing Tax Credit and the Affordable Care Act’s premium tax credit.
ESTATE PLANNING
In the estate and gift tax world, Biden is proposing some significant changes with the primary change that has had tax planners scrambling for months, being Biden’s proposed reduction of the gift tax exemption to $1 million coupled with a reduction of the estate tax exemption from the current $11.58 million to $3.5 million, or at least an end to the TCJA bonus doubling of the exemption amount before 2026. Biden’s proposal would also increase the top rate for the estate tax to 45%.[7] Biden has also proposed a repeal to the step-up in basis on assets at death and even the potential to cause death to be a recognition event.. As Charles stated in his previous article, “This would subject such appreciated assets to gain in the hands of heirs when sold, and almost act as a double taxation scheme for assets in which are subject to the estate tax at their fair market value but do not receive a stepped up income tax basis to that fair market value.”[8] This would affect all beneficiaries who receive appreciated assets, not just those who are beneficiaries of high net worth estates.
TAX PLANNING
Many taxpayers have been taking advantage of existing tax benefits while simultaneously planning for the eventuality that Biden would win the election. While the best tax planning strategy would probably be to drop dead, and thereby lock in the current tax regime, few taxpayers seem inclined to do so. Perhaps the most prevalent planning strategy has been using the current $11.58 million estate and gift tax exemption before it returns to $3.5 million, if in fact it does so. With the publishing of the final regulations under IR-2019-189 on November 26, 2019, the IRS confirmed there would be no “clawback” of gifts made at a given exemption amount in the event that the exemption is reduced in future years. This has led to a use-it-before-you-lose it mindset for many taxpayers in 2020, knowing that Biden plans to significantly reduce the exemption.
Some tax planners have also suggested that making taxable gifts in excess of the exemption is advisable due to the proposed increase to the estate tax rates. Such would have the effect of at least allowing any growth to occur outside of the taxable estate. This strategy also takes advantage of the tax exclusive nature of the gift tax as opposed to the tax inclusive nature of the estate tax, a benefit that is often overlooked. The gift tax is not assessed on the money used to pay the gift tax, thus the term tax exclusive. For example, if a taxpayer makes a $1 million gift, and pays $400,000 in gift tax, the donee still receives the full $1 million and the additional $400,000 used to pay the tax is now out of the donor’s estate and not subject to gift or estate tax. On the other hand, the estate tax is assessed on the money used to pay the estate tax, thus the term tax inclusive. Let’s take the same $1.4 million from our gift tax example and subject it to a 40% estate tax. The tax owed is $560,000 leaving the beneficiary of the estate with $840,000, $160,000 less than if the donor had used the same $1.4 million for a lifetime taxable gift. All else being equal, at a 40% tax rate, paying the gift tax which is tax exclusive results in a 28.57% effective tax rate on the total value of the money used to make the gift plus the tax, while the same would be subject to a 40% tax rate under a tax inclusive estate tax.[9]
While planning for income taxation generally provides less flexibility than planning around estate taxation, many advisors have also suggested that taxpayers convert as much of their IRAs to Roth IRAs in anticipation of increased income tax rates.
Finally, while the wait-and-see approach seems to be a good approach, this could be unwise, since tax law changes could become effective as early as January 1, 2021. In addition to wait and see planning there are several flexible planning strategies that allow assets to be returned to the taxpayer’s taxable estate, including potentially returned to the taxpayer if the gifting was not necessary, and are worth considering. Many trust structures can be drafted with these flexible provisions such that gifting need not lock in the planning. The taxpayer can get access to money if needed later for non-tax reasons, and the assets can be added back to the estate if needed for tax reasons.
DIFFICULTIES FOR BIDEN
It is worth noting that Biden’s proposed reforms might not be as easy to pass as some believe, owing to the fact that the current status of the Senate is in an unfavorable position for Biden. As of the publishing of this article, the Associated Press has called forty-nine seats for the Republicans compared to the forty-six held by the Democrats and the two held by independent parties. It is worth noting that the two held by independent parties tend to vote with the Democrats, essentially giving the Democrats forty-eight seats. Georgia’s two Senate seats are yet to be determined and will go to a runoff set for January 5, 2021. The final seat is in North Carolina where the Republicans have a slight edge and the Democratic opponent has conceded. Assuming the Republicans manage to secure the North Carolina seat, even if both of the Georgia seats are claimed by the Democrats, that leads to the Republicans holding fifty percent of the Senate. At a 50/50 vote along party lines, the tie-breaking vote would be held by Vice President-elect Kamala Harris, thus giving the Democrats the edge. However, this would require each and every Democrat to follow the party vote assuming no Republicans break ranks, something that may not be so sure to happen when it comes to major tax changes such as dropping the estate tax exemption to $3.5 million and eliminating a stepped up basis at death, but much more likely to happen for moderate tax changes such as increasing the top individual income tax rate from 37% to 39.6%. Of course, if the Republicans do hold North Carolina and manage to secure at least one of the Georgia Senate seats, then the Republicans would control the Senate, and any Democratic tax plan would require at least one Republican Senator to break ranks.
CONCLUSION
The clock is ticking for taxpayers to take advantage of the many benefits available under the current tax regime. With less than two months left in the wonderful year that is 2020, taxpayers (especially those who earn more than $400,000 per year and/or plan to pass on more than $3.5 million in wealth) should consider meeting with their tax advisor to do some year-end tax planning prior to January 1, 2021. While retroactive legislation may not be likely, it could happen such that any reduced exemption is applicable for transfers starting on January 1, 2021 notwithstanding that Biden is sworn in at a later date.
[1] Joe Biden Campaign, “A Tale of Two Tax Policies: Trump Rewards Wealth, Biden Rewards Work,” https://joebiden.com/two-tax-policies/.
[2] Id.
[3] Id.
[4] The Pease Limitation on itemized deductions essentially reduced the value of a taxpayer’s itemized deductions by 3 percent for every dollar of taxable income above a certain threshold ($261,500 for single taxpayers in 2017).
[5] Id.
[6] Id.
[7] CNBC, “This is how Joe Biden will tax generational wealth transfer,” https://www.cnbc.com/2020/03/13/this-is-how-joe-biden-will-tax-generational-wealth-transfer.html
[8] Democratic Presidential Candidates: Tax Plans, https://esapllc.com/democrat-tax-proposals-2020/
[9] Calculated as follows: $400,000 (tax paid) / $1,400,000 (total cost to donor)
