During last year's campaign, then-candidate Joe Biden stated that he would use higher taxes to partially fund various spending priorities if he were elected president. Now that the Democrats control the White House and both the House and Senate, tax increases could be on the horizon. Details of the Biden administration's proposed tax changes are gradually coming into focus, and on March 31, President Biden unveiled his infrastructure spending plan, which will be funded in part by an increase in the corporate tax rate to 28%.
Below is a wealth advisors' tax planning specialists review of some of the specifics of Biden's proposed tax changes and how they would affect individuals and households. They also offer some suggestions for how taxpayers can proactively mitigate the impact of these proposed changes.
What are some key areas of focus in Biden's tax plan? When would potential changes take effect, and whom would they impact the most?
First, it is important to keep in mind that it remains unclear which aspects of Biden's proposed tax changes will become law. Democrats control both chambers of Congress, but they control the Senate by the narrowest of margins. Moderate Democrats will likely push back in some areas, and certain changes to the tax law would likely require 60 votes to pass the Senate (although others could be passed using the reconciliation process, which requires a simple majority).
Nonetheless, tax increases seem likely due to a number of factors, including the fact that some tax rates are at the lower range of historical levels, and there appears to be some bipartisan support for infrastructure spending and other spending initiatives.
Biden's plan focuses on increasing taxes for high-income individuals and families, and corporations. Biden has repeatedly stated that taxes won't increase for households earning less than $400,000 per year. If your household income is below that threshold, you most likely won't be affected in a significant way, and you may even face lower taxes under Biden's plan.
Assuming a bill isn't passed until mid-2021, or later, we believe that it is unlikely that tax changes would be applied retroactively to January 1, 2021, although that is possible. The Biden administration already has an ambitious agenda on its plate, so any significant tax changes will likely take time. That gives individuals and families time to plan ahead.
How would personal income taxes, retirement plan contributions, and other key areas be affected?
Under the plan that Biden touted on the campaign trail in 2020, the top marginal income tax rate would increase from 37% to 39.6%. This would restore the top rate that was in effect prior to tax cuts made in 2017. Note that the 37% rate is already scheduled to revert back to 39.6% after 2025.
Biden's tax plan would tax capital gains as ordinary income for taxpayers whose annual income exceeds $1 million. If you are in this category, Biden's plan would nearly double your capital gains tax rate, from 23.8% to 43.4%. However, many tax experts believe that an increase in the capital gains rate to 25%–28% is more likely.
Under Biden's plan, Social Security taxes would be imposed on earned income in excess of $400,000. Currently, workers aren't assessed Social Security tax on any income beyond the Social Security wage base, which is $142,800 in 2021.
Deductions for contributions to 401(k)s, traditional IRAs, and other types of qualified retirement vehicles would be replaced with a refundable tax credit of 26%. Taxpayers would receive the full credit even if it is more than what they owe in taxes. For some people in a tax bracket higher than 26%, however, the credit may be less valuable than the current deduction system.
For business owners and partners, we also note that Biden's tax plan would raise the corporate income tax rate from 21% to 28% and phase out the qualified business income (QBI) deduction (Section 199A) for individuals with income over $400,000. On March 31, Biden confirmed his plan to increase the corporate tax rate as well as implement measures designed to prevent the offshoring of corporate profits.
What are some potential changes to estate taxes? How can families plan ahead for these potential changes?
Under Biden's plan, the estate tax exemption would drop from $11.7 million per person ($23.4 million per married couple) to $3.5 million per person ($7 million per married couple). The current estate tax exemption is set to automatically "sunset" after 2025 and return to $5 million per person ($10 million per couple), adjusted for inflation. We expect pushback on Biden's potential change, perhaps resulting in a compromise that puts the exemption somewhere in the neighborhood of $5.5 million per person ($11 million per married couple). Another key component of Biden's plan is the elimination of the step-up in basis on assets received through an estate. This could have tremendous implications when inheriting assets.
Considering the likelihood that the estate tax exemption will decrease significantly, we encourage clients to examine the wealth transfer structure they have established for their families and beneficiaries. But we would hesitate to make any radical changes to estate plans until it is clear that the exemption will dramatically decrease.
Assuming the current estate tax exemption will be reduced to some extent, there are a few ways to use the $11.7 million exemption now. Two approaches are Spousal Lifetime Access Trusts (SLATs) and Grantor Retained Annuity Trusts (GRATs). In a SLAT, one spouse transfers assets to an irrevocable trust for the benefit of the other spouse, up to the donor's available exemption, without incurring a gift tax. With a GRAT, the value of specific assets in an estate is frozen, and any potential appreciation is transferred to the trust's beneficiaries, with little or no gift tax. Donors receive an annuity stream from the assets for the period provided in the transaction.
The GRAT uses an Intentionally Defective Grantor Trust (IDGT). With this planning technique, the value of the assets sold to a trust are frozen for estate tax purposes, but the grantor retains certain interests causing the grantor to be responsible for paying taxes on the trust income. The assets grow tax-free, the trust beneficiaries avoid gift tax, and the grantor's estate is no longer exposed to the increase in the assets' value. Note that Biden's tax plan may eliminate discounts, a key component of this transaction, so those who wish to use this strategy should consider acting soon.
A similar transaction to the GRAT is a sale to a defective trust. The benefits are comparable, but this technique also provides a bigger benefit by transferring more assets to beneficiaries. In addition, a sale to a defective trust is more attractive from a Generation-Skipping Transfer Tax exemption perspective.
Business owners have additional flexibility to transfer assets to the next generation. For example, a business could be transferred to a trust for the benefit of the owner's children, or ownership could be transferred to the children directly.
Lastly, charitable lead trusts may also be worth considering. Income from the trust flows to one or more charities, with estate or gift tax savings on assets that are later passed to the trust's designated beneficiaries.
For more information about the above article or other wealth management services, contact Michael D. Machen, CPA, CVA at (334) 887-7022 or by leaving us a message below.
This article originally appeared in BDO USA, LLP's Insights/Advisory/BDO Wealth Advisors - April 2021. Copywrite 2021 BDO USA, LLP. All rights reserved. www.bdo.com.
