Proactive measures for the rich to consider before possible changes in tax laws
The recently proposed changes to tax legislation, if passed, will significantly change the landscape of tax and estate planning for high net worth individuals. While the final form of these proposals is far from certain, high net worth individuals should consider taking steps this year to mitigate the risk of potentially adverse tax law changes.
Context and current law
Under current law, the federal gift and inheritance tax exemption amount is the highest ever. Individuals can currently donate up to $ 11.7 million in assets during life or death without triggering gift or inheritance tax. Couples can donate up to $ 23.4 million tax free.
The current amount of the large exemption is expected to return to pre-2018 levels starting in 2026. When that happens, the exemption will decrease to approximately $ 6 million. Donations exceeding this amount will result in gift or inheritance tax, calculated at approximately 40% of the value of the transferred assets.
Currently, neither lifetime gifts nor bequests trigger income taxes for those who receive them. Recipients of lifetime gifts take a “transfer” basis in the donated property, thus preserving any unrealized gain. Assets that pass on death receive a base âincreaseâ to fair market value, effectively eliminating any unrealized gain on assets held at the time of death.
Proposed changes to tax legislation
At the end of May, the US Treasury Department published General explanations of the Administration’s revenue proposals for the 2022 financial year (aka the “Green Book”), outlining a description of the administration’s revenue proposals. The Green Paper contains several proposals which could have a considerable impact on the tax obligations of wealthy taxpayers.
The administration proposes to increase the top tax rate for individuals (and presumably trusts) from 37% to 39.6% (the rate in effect before 2018). For 2022, this higher rate would apply to taxable income greater than $ 509,300 for joint filers and $ 452,700 for single filers. After 2022, the ranges will reset to reflect inflation. This change is proposed to begin in 2022.
The administration also proposed to tax long-term capital gains and eligible dividends at ordinary income rates for taxpayers with adjusted gross income over $ 1 million. This change would result in a federal tax rate of up to 43.4% (proposed 39.6% + 3.8% net investment income tax). The higher tax rate on long-term capital gains and eligible dividends would only apply to the extent that the taxpayer’s AGI exceeds $ 1 million. This change is proposed to take effect in April 2021 (that is to say, retroactively from the date of future adoption).
Finally, the administration plans to treat donations and transfers on death as income realization events. Donations and bequests would be treated essentially as if the donor (1) were selling the property, realizing a gain or a loss; (2) redeemed the property; and (3) donation of identical replacement property, meaning that any previously unrealized gain would be recognized by the donor and income taxes paid on the âphantomâ gain. Most transfers of appreciated property and distributions from trusts (including most transferor trusts) would also trigger recognition of gains.
As currently proposed, transfers of valued property to a charity would not generate a taxable capital gain. Additionally, each person could exclude $ 1 million from the phantom recognition gain (a lifetime exclusion for gifts or transfers on death). Transfers to a surviving spouse on death would not trigger immediate recognition of the gain, but the surviving spouse would use a deferral basis in the transferred assets, which means that the tax liability would be triggered on the death of the surviving spouse or sooner. ‘it was offered during his lifetime. This change is proposed to begin in 2022.
The Green Paper did not propose any changes to the current laws on gift and inheritance tax. As part of the income realization proposal, the donor may be subject to both income taxes and transfer duties on the same transfer. In addition, long-term capital gains generated by donations may be taxed at higher regular tax rates.
Planning considerations for 2021 and beyond
It is important to remember that the proposals in the Green Paper are just that – proposals. The legislative process will undoubtedly change the details of any final bill significantly. The forces of compromise and political expediency can reduce the harshness of such proposals (including whether any of the proposals have retroactive effect). However, wealthy taxpayers may want to take some steps to proactively protect themselves:
- With the prospect of higher tax rates looming, higher income earners (and potentially trusts) may want to withdraw income in 2021. For example, people who are considering converting a traditional IRA to a Roth IRAs may want to take this step before until the end of 2021, when the highest tax bracket might be lower.
- Keeping the future year’s AGI below $ 1 million can also be used to avoid higher rates on long-term capital gains and eligible dividends. Consequently, the deferral of deductions (for example, charitable contributions) until 2022 or later may make the deduction more attractive, given the proposed changes.
- Taking advantage of the current decline in long-term capital gains tax rates by triggering capital gains recognition in 2021 may be advisable for some, especially if the sale makes sense for non-tax reasons. (for example, diversification). There are no rules prohibiting washing gain transactions and appreciated securities can be redeemed immediately without penalty. Given the uncertainty of what final tax laws will take, accelerating large gains can be risky; it may be better to take a wait-and-see approach.
When it comes to estate planning, a few other options come to mind:
- Although the fear of a short-term gift and inheritance tax exemption has been removed, from 2022 large donations can trigger a large income tax on phantom earnings (which can be taxed at a higher rate). If future transfers on death trigger income recognition, making donations in 2021 may make sense – both to avoid gaining recognition on future donations and to use the historically significant exemption from income tax. donations. For individuals or couples whose financial independence (and personal risk tolerance) allows them to use their residual gift tax exemption, 2021 gifts remain advantageous.
- The transfer of higher base assets into one’s taxable estate may reduce the impact of the proposed earnings recognition rule on transfers at death. Traditional planning often involves the transfer of low-tax assets to an individual’s personal name or revocable trust. This is designed to ensure the inclusion of low base assets in the person’s taxable estate in order to achieve an increase in base upon death. Under the proposed changes, possession of low value assets on death may result in significant income tax; dying while holding higher asset base can mitigate this risk.
The bottom line
People who are considering making changes to their estate plans should seek detailed advice from an experienced tax professional. Depending on the individual circumstances, certain actions may work against you if the final laws differ from the proposed changes. Hopefully, the details of future tax law changes will become clearer in the coming weeks, which will make the planning results more certain.
Lawyer in the family office, Keel Point
Douglas Andre is the Family Office Lawyer for the Horizon Family Office team. Prior to joining Keel Point, he was a partner at Ivins, Phillips and Barker in Washington, DC, focusing on national and international income tax and estate planning. Doug began his career as a naval officer and aircraft carrier pilot. He began his legal career after leaving the Navy, helping clients manage their compliance and tax and estate planning. In addition to being a lawyer, he is a certified CPA.