Tax Alert 2021-03

Courtesy Merrill Lynch

Likelihood of Tax Changes: Becoming Clearer But a Long Way to Go

 There will be a determined effort to eliminate the Trump tax cuts (enacted under the Tax Cuts and Jobs Act of 2017) for taxpayers with income over $400,000, and particularly to:

– Increase top marginal tax rate from 37% to 39.6%

– Limit the value of itemized deductions, as if the taxpayer were in no greater than a 28% bracket; along with this effort could be an increase in the cap (currently set at $10,000) for state and local tax (SALT) deductions

  • Democrats can enact such changes without any Republican support, via the budget reconciliation process
  • Possible effective date:

– A desire for more revenue to offset other spending priorities of President Biden could favor a retroactive effective date (for instance, January 1, 2021) BUT, a fragile Covid-19 economic environment and sentiments from Treasury Secretary Janet Yellen and other Biden advisors indicate a favored prospective effective date (for instance, January 1, 2022)

It is projected that these tax changes would raise about $430 billion over 10 years.1

Capital Gains and Qualified Dividends

  • There could be a strong effort to eliminate the current preferential tax rates for qualified dividends and long term capital gains (current top rate of 20%), at least for taxpayers with over $1 million in gross income. This is a Biden proposal and has been a long-standing priority among some Democrats, including the current chair of the Senate Finance Committee.

– Such a change not only raises revenue but also addresses income and wealth inequality issues

– Democrats can enact such a change without any Republican support, via the budget reconciliation process

– The challenge for Democrats will be getting sufficient votes: without any Republican support, will need all 50 Senate Democrats (with Vice President Kamala Harris casting the tie-breaking vote) and 98% of House Democrats, a fair number of whom are from affluent suburban districts which lean Republican

– This could result in a compromise and a more moderate rate increase from the current top rate of 20%, to perhaps 28%, rather than to Biden’s proposed top income tax rate of 39.6%

  • Possible effective date:

– Capital gain rate changes could be more nuanced than regular tax rate changes and therefore it is unclear when any change would be effective.

– There is a history of not imposing capital gain tax rate increases on a retroactive basis. Past changes were generally effective at the beginning of a subsequent tax year or on the date of introduction or enactment of the tax bill. Sentiments shared by Treasury Secretary Yellen and other senior appointees of President Biden indicate a preference to refrain from a retroactive change. This could mean such a change could take effect January 1, 2022 (or earlier, which could be the date of introduction of a tax bill).

However, it appears unlikely to see a retroactive increase in capital gain rates.

It is projected that this tax change would raise about $469 billion over 10 years.1

TRANSFER TAXES

Transfer Taxes (Estate, Gift and Generation Skipping Transfer (GST) Taxes)

  • There will be a concerted effort to reduce the estate, gift and GST tax exemptions (currently set at $11.7 million per person) and perhaps to increase the estate, gift and GST tax rates (currently set at 40%).

Democrats have previously sought to return transfer taxes to 2009 parameters: an estate and GST tax exemption of $3.5 million; a gift tax exemption of $1 million, and a top transfer tax rate of 45%

– While there have been very few details of any Biden transfer tax proposals, the Biden campaign website contains “Highlights of Joe Biden’s Plans to Support Women During the COVID-19 Crisis.” These highlights include a section on providing family, medical and safe leave, as well as sick and safe days and indicates: “Biden will pay for this proposal by returning the estate tax to 2009 levels.” Although this only refers to the estate tax, presumably it would also include the 2009 parameters for the gift and GST tax

  • There may also be an effort to eliminate the step-up in basis on estate included assets

– This is a Biden tax proposal – but it could be subject to two different interpretations: one being a tax imposed at death on unrealized appreciation, the other being a carry-over of the decedent’s tax basis in assets so that a capital gain tax would be due upon the beneficiary’s subsequent sale

  • Regulatory changes could curtail valuation discounts and other popular estate planning strategies, including grantor retained annuity trusts (GRATs).
  • As noted, Democrats can enact such changes without any Republican support, via the budget reconciliation process
  • Because of the thin Democratic majorities in the House and Senate, legislation could vary from prior Democratic proposals: perhaps, a more moderate reduction in the estate, gift and GST tax exemptions – to, for instance, $5 million per person
  • The elimination of a step-up in basis on death would affect many taxpayers not otherwise currently subject to an estate tax

– There could be a step-up in basis limited to a specified amount of appreciation so that beneficiaries of smaller estates would not be exposed to additional capital gains taxes (such a rule was in place in 2010)

  • Possible effective date. A prospective effective date – for instance, January 1, 2022 – is possible for changes in transfer tax exemptions and rates

– There is an inherent unfairness of changing the tax rules retroactively for gifts and could actually have a punitive effect on those who have already undertaken planning

– Like the effective date for capital gains, a change in step-up in basis rules could be based on date of legislation

  • It is projected that this tax change would raise about $280 billion over 10 years (revenue projection for changes in step-up in basis included in capital gains changes above)1

SOCIAL SECURITY TAXES

President Biden has indicated that Social Security reform is a priority for his administration.

  • To address the solvency of the program, he has proposed imposing the 6.2% Social Security tax (12.4% for both workers and employers) on an unlimited amount of earned income over the threshold of $400,000
  • Technical procedural rules make it difficult to include a Social Security tax rate increase in a reconciliation bill, and therefore changes in this area seem unlikely

It is projected that this tax change would raise about $820 billion over 10 years.1