The tumultuous Democrat primary for president yielded a consensus about both the candidate and the overall direction of federal tax policy. Here’s an overview of Vice President Joe Biden’s broad policy proposals for the income and transfer tax systems and some suggested strategies to cope with them. Many of the proposals will impact the decision of when to make charitable contributions. The ability of Congress to impose retroactive tax increases should prompt clients to act now rather than wait until early next year.
Additions to the National Debt
The federal bailout of the COVID-19 damaged economy added another $3 trillion to the principal on the debt, and that number continues to rise. While the debt service as a percentage of federal revenues is manageable in an era of historically low interest rates, the government’s ability to respond to future crisis is constrained.1 The moment draws nearer for the first dramatic redesigning of the Internal Revenue Code since 1986. Unlike that reform, the environment of rising deficits previously unimaginable a few years ago means that it won’t be “revenue neutral.” Should the executive and both legislative branches be under Democrat control, only a simple majority will be needed to raise taxes. Should the Republicans retain control of the Senate, the scope of reforms likely will be reduced.
Proposals to Watch
The following proposals are getting the most legislative attention and will require coping responses.
Raising the marginal rates on the earned and investment income of the highest incomes.Under current law, individuals making over $518,000 and couples making over $622,000 pay the top 37% rate. In 2026, the top rate returns to its 2013-2018 level of 39.6%. Under Biden’s proposals, taxpayers with earned income exceeding $400,000 will be coping with potentially five tax increases. Income over $400,000 will be subject to the Social Security tax of 12.4%.2 The top nominal marginal rate will be 39.6%.3 In effect, it will be higher after restoring the 3% Pease limitation (reducing the value of itemized deductions for high income taxpayers) and capping itemized deductions to 28%.4 For taxpayers with income exceeding
$1 million, capital gains will be taxed at the top rate on ordinary income of 39.6%.5
The IRC Section 199A deduction for qualified business income (QBI) will have a lower phaseout, and the tax rate for C corporations will rise from 21% to 28%.6
Managing compensation flow and recognition of long-term capital gains. The traditional techniques of deferring compensation into hopefully lower rate years will be fruitful, especially for avoiding the expanded base for Social Security or Federal Insurance Contributions Act (FICA) tax. The spread for an incentive stock option is exempted from the FICA tax.7 The FICA tax on a non-statutory option spread can be deferred to the time of exercise.8 A major goal of deferred compensation planning will be reaching the safety of the no-tax zone between the limit of the Social Security taxable wage base and $400,000.
Gain harvesting would make better sense now; loss recognition would be more valuable in 2021 should the higher rates on capital gains and compensation income be enacted. The ordinary loss deduction of $3,000 becomes more valuable.
Itemized Deductions
The present value of a tax paid later is less than a tax paid now. Accelerating deductions usually makes sense but needs rethinking in an environment of increased marginal rates, higher standard deductions and additional limits on itemized deductions. To discourage the value of deductions in years of higher rates, the Biden plan limits the tax savings to 28% of itemized giving and reinstates some form of a Pease limitation.
If restored to its prior form, the Pease limitation would reduce the amount of allowable itemized deductions by the lesser of either 3% of the excess of the taxpayer’s adjusted gross income (AGI) over an inflation-adjusted threshold such as AGI of $400,000 or 80% of the impacted deductions such as charity, mortgage interest and state and local tax (SALT) deductions.
The return of the Pease limitation, coupled with the current historically generous standard deduction limits, could eliminate the value of itemizing.
Example: Harry and Sally, married filing jointly, have an AGI of $700,000 with $28,000 itemized deductions attributable only to the impacted deductions; namely, mortgage interest, charity and SALT. In 2021, the reduction would be the lesser of 3% of $300,000 ($9,000) or 80% of $28,000 ($22,400). The reduction of $9,000 leaves Harry and Sally with itemized deductions of $19,000, making the standard deduction of $24,800 superior.
Timing Charitable Contributions
Charitably inclined clients who want to save on taxes will find donor-advised funds (DAFs) and charitable remainder trusts (CRTs) valuable.
DAFs. The strategy of bunching charitable deductions for contributions to a DAF is becoming increasingly attractive. While the Coronavirus Aid, Relief, and Economic Security Act’s exclusion of DAFs from being public charities qualifying for the 100% of AGI limitation might be a harbinger of future legislative restraints, it remains attractive.
CRTs. Charitably inclined clients can use the CRT to annuitize an appreciated position without diminution of principal by capital gains taxes while securing a charitable deduction. The CRT can also dramatically improve cash flow from appreciated stock, most of which are paying dividends under 3%. If the client creates the CRT this year, the after-tax savings will possibly be greater than if he waits until 2021.
Qualified charitable distributions (QCDs). Taxpayers who need a required minimum distribution (RMD) and/or take the standard deduction can make a QCD to a public charity to reduce the income tax bite otherwise owed for an individual retirement account. While not deductible, the QCD is credited against the RMD. The net effect is like a tax deduction. While the Setting Every Community Up for Retirement Enhancement Act raised the RMD age to 72, it left intact at 70½ the age for qualification for a QCD. The QCD’s excludability from gross income can also limit the taxability of Social Security benefits and the net investment income tax.
Transfer Taxes
Should Congressional inertia prevail through Dec. 31, 2025, the dramatically lower exemptions will return. So, using the maximum exemption this year may never make more sense given the possibility of dramatic reductions or worse.
Repeal of Step-Up in Basis
The worst proposal for high-net-worth clients is the repeal of the step-up in basis for accrued gains at death. While the annual or lifetime increase in wealth is income in an economic sense, eliminating the basis step-up would be controversial. For ideas on how to tax accrued income, a Biden presidency needn’t look further than the Obama era proposals of taxing capital gains at death with perhaps exclusions based on the size of an inheritance ($100,000) and the nature of the asset ($250,000 for primary residence).9 If perceived as likely to be enacted, the proposal would trigger significant gifts and asset sales. Those estates and heirs seeking to hold inherited and gifted assets will especially need to create liquidity in an estate plan. Gifts to educational and medical service providers might also be more attractive.
Wealth Tax
Senators Bernie Sanders’ and Elizabeth Warren’s proposals for a wealth tax never got traction. But, California Assembly Bill 2088 has gotten attention. It would impose a 0.4% wealth tax on all taxpayers with a net worth of at least $30 million ($15 million for married couples filing separately).10 Fleeing the jurisdiction won’t provide full relief as there’s a prorated 10-year phase-out of the wealth tax. Correspondingly, there’s a 10-year phase-in for those moving into the state. While the tax is estimated to impact 30,400 Californians, it annually will raise $7.5 billion.11
Assuming a wealth tax at the federal level survives the inevitable constitutional challenge, it nonetheless has the difficult administrative problems of valuation, auditing and responding to capital flight. The reduction from 12 to four European nations12 imposing such a tax should be a cautionary tale that the wealth tax isn’t a bottomless well of revenue.
Retroactive Tax Increases
In assessing the effectiveness of any tax planning strategies for 2020 and 2021, practitioners must prepare for the possibility of retroactive tax increases.
If the retroactive taxation of a transaction is a rationally legitimate purpose, it passes muster under Pension Benefit Guaranty Corporation v. R.A. Gray & Co.13 and United States v. Carlton.14 Under the applicable standard, a tax statute’s retroactive application must be supported by a legitimate legislative purpose furthered by rational means.
The rational means test should be an easy threshold for retroactive income taxes to meet in a time of fiscal crisis occasioned by a pandemic. Whether Congress would ever retroactively impose a tax increase to a completed tax year (2020) in the name of addressing pandemic spending is a question taxpayers hope not to contemplate. But, a retroactive increase to a prior year has survived a challenge.15
As wild a roller coaster ride 2020 has been, next year has the potential to be even wilder.
Endnotes
1. Interest expense divided by total revenues is a manageable 10%. However, the principal on the debt now exceeds the U.S. economy for the first time since World War II. For an up-to-the-minute update, seewww.usdebtclock.org. As long as governmental and institutional investors believe the United States is creditworthy, the borrowing will continue.
2. Seewww.taxpolicycenter.org/publications/analysis-former-vice-president-bidens-tax-proposals/full.
3. Ibid., at p. 1.
4. Ibid.
5. See supra note 1.
6. Ibid., at p. 2.
7. Internal Revenue Code Section 3121 (a)(2).
8. IRC Section 83(a); Treasury Regulations Section 1.83-7 (a).
9. Office of Management and Budget, Executive Office of the President, Budget of the United States Government, Fiscal Year 2017 (2016); Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2017 Revenue Proposals (Greenbook) (February 2016).
10. Seehttps://leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201920200AB2088.
12. See OECD (2018), The Role and Design of Net Wealth Taxes in the OECD, OECD Tax Policy Studies, No. 26, OECD Publishing, Paris, https://doi.org/10.1787/9789264290303-en.
13. Pension Benefit Guaranty Corporation v. R. A. Gray & Co., 467 U.S. 717 (1984).
14. United States v. Carlton, 512 U.S. 26 (1994). The federal court in U.S. Bank N.A. v. U.S., 74 F. Supp.2d 934 (D.Neb 1999) upheld the constitutionality of retroactive increases in the estate tax rate and the retroactive appeal of an estate tax reduction.
15. Stockdale v. Atlantic Ins. Co., 87 U.S. 323, 331 (1874) affirmed the taxation of income from a prior year with retroactive legislation.