Proposed Tax Increases: How to plan; what to do
Does anyone enjoy paying taxes?
We understand that some level of tax should be paid, but no one desires to pay more than necessary. This leads to much time and expense being spent in creating a strategy for tax minimization.
Despite the widely variable marginal tax rates that can make the news cycle, according to Congressional Budget Office data taxpayers’ average historical tax rate is nearly half of the highest tax bracket in any given decade. For example, our highest tax bracket is currently at 37%, but taxpayers in 2018 paid an effective rate of about 18%.
In the face of proposed tax increases, many will spend time and money planning not to pay the top marginal rates but rather a rate that is effectively much lower.
Since the enactment of the Trump tax cuts (TCJA) beginning in 2018, relentless tax planning challenges have been faced by many. Strategies for effective planning struggle to keep pace with recently enacted and pending legislation. What follows may clarify some of the fundamental changes in taxation that are being proposed while sharing basic planning concepts that I hope can provide an answer to the question, “Now what do we do?”
Default tax increase on the horizon: It is easy to forget just how many provisions of TCJA benefited individuals and small businesses and that 2025 is the final year to enjoy most of those provisions. The Biden administration is working to accelerate the expiration of specific TCJA provisions, such as increasing the top marginal individual and corporate tax brackets and modifying, or in some cases eliminating, the pass-through deduction for businesses. Congress is already considering both.
How to plan: Accelerate income into this year (i.e., ROTH conversion). It is highly unlikely that changes to income tax (not to be confused with a capital gains tax) would be retroactive for 2021.
Capital gains tax: Capital gains tax is a hot topic. The sale of securities, crypto currency, real estate, businesses, etc., can trigger a capital gain. A capital gains tax is levied on the increase in value over what you had originally paid for an asset. Observe that some of this gain is not entirely the result of an asset becoming more valuable, but rather due to inflation. For example, owning an asset that increases in value at the same inflation rate is considered a hedge against inflation. Still, a tax assessment on that “gain” can invest an after-tax loser, especially if the tax rate is doubled.
Our current maximum long-term capital gains tax rate for higher-income earners is set at 20%. The Biden administration proposes that those with incomes of over $1 million be charged a capital gains rate that matches the highest ordinary tax bracket.
That bracket is proposed to be 39.6% and, when coupled with a 3.8% net investment income tax and a 4.25% Michigan income tax, a 47.65% tax rate on that gain could be assessed. Even though this tax rate may not activate until income exceeds $1 million, I believe this could snare more taxpayers than initially thought.
I meet many individuals who inherit valuable assets from a relative who had paid relatively little for that property many decades ago. Suppose that property’s cost basis is not allowed to reset to market value (see next section). In that case, those receiving such inheritance could find themselves paying an exorbitant tax rate upon the sale of the inherited property.
Also, middle-class retirees selling their businesses or liquidating employer stock could find themselves paying a high price for a once-in-a-lifetime event.
How to plan: This provision has a high potential to be retroactive for 2021. To slide under the $1 million threshold, it’s best to mix several strategies: defer other income, increase charitable giving, and/or accept more risk by selling under an installment agreement to spread taxable income across multiple tax years.
Inheritance tax: Losing the family farm or business to tax has been a long-held worry. Twenty years ago, estates valued up to $1 million were exempt from taxation, but this exemption is currently at $11.7 million, causing very few farms and businesses to be lost. The estate tax rate has ranged between 35% and 55%, and the Biden administration is proposing a 45% tax rate on estates valued at more than $3.5 million.
One’s lifetime accumulation of retirement accounts, residential/commercial investment property, a homestead, a small business, and even some life insurance could add up to exceed the proposed $3.5 million exemption. Couple this with a current proposal to not allow cost basis to reset upon death. Not only could significant estate taxes be owed, but those who inherit highly appreciated assets could be stuck with hefty capital gains taxes – several caveats apply. Let’s hope that more provisions will be made to eliminate this potential for double taxation.
How to plan: Use this year’s historically high exemption to transfer appreciable assets out of your estate. Since that’s easier said than done, an estate planning professional must be consulted.
We do not know what the final form of tax legislation will look like, but with soaring national debt promulgated by massive deficit spending, tax increases appear inevitable but can certainly be planned for in advance. Most may not escape a higher tax burden, but with proper planning, most can minimize their effective tax rate.
Jeff Wood, CPA, is a partner with Intrust CPA providing tax preparation and planning services for individuals and businesses. He’s been in public practice for 20 years. Learn more at intrustcpa.us. The information in this article is to provide information on tax planning ideas. We encourage you to consult with your own tax and estate planning professionals.