The Swing of the Tax Pendulum and Planning Considerations

Here we are coming upon the fourth anniversary of the one of the most shocking nights of our country since perhaps the Battle of Saratoga and one of the largest cash outlays by our government ever known by means of the CARES Act. On the heels of these events Democrats are setting the stage to potentially initiate sweeping changes to the tax law. Particularly, word is floating around about several changes that could come following a Biden success. This article is very much a “what-if” analysis and is not intended to be any indicator of expectations. But, the mental exercise may prove useful if the changes do come.

Overview

Based on information provided by the Tax Foundation,[1] noting that Biden has not yet released a single formal tax plan, certain potential changes could be as follows:

  • Phase-out of the (up to 20%) 199A deduction on qualified business income for those earning over $400,000;
  • Raising the top income tax rate for individuals from 37% to 39.6%;
  • For those earning $1 million or more, taxing capital gains at ordinary income rates;
  • Taxing unrealized appreciation upon death
  • Elimination of the step-up in cost basis at death;
  • Instituting substantial limitations on itemized deductions for high-income earners;
  • Raising corporate income tax from 21% to 28%;
  • Imposing the 12.4% Social Security payroll tax on wages and self-employment income earned above $400,000;
  • Bring back the Pease limitation on itemized deductions; and
  • Reduce estate and gift tax exemptions possibly by accelerating the scheduled January 1, 2026 reduction in half (currently, this would reduce the exemption from $11.58 million to $5.79 million) or possibly by setting an exemption as low as $3.5 million.

The Planning Ideas

Ok, so what do we do? For now, perhaps nothing. It would certainly take a while for changes to  become law. For instance, the Tax Cuts and Jobs Acts (“TCJA”) was passed at the end of 2017, effective January 1, 2018, almost a year into the Trump presidency. Further, there would likely need to be a change in power in Congress as well for these changes to pass. As sweeping as these potential changes could be, it would be incredibly surprising to see all of this occur in a single tax bill. If the changes do occur, there could be many planning opportunities for wealthy taxpayers.

Often, we tell our clients we can help them tremendously in preserving wealth from estate and gift taxation. Unfortunately, for many, while we can help, plan, and mitigate income taxes to an extent, income tax is generally a virtual certainty and is the effect of accessions to wealth. From the income tax end, there would be whip-saw effect for wealthy taxpayers, less deductions and higher tax rates. Also, stack on additional employment taxes and higher corporate income tax rates. So, there may be a few things that can be done here.

Spend?

Often, we see taxpayers hunting year-end purchases to capture expensing opportunities to decrease their taxes, in effect subsidizing their capital expenditures. However, this all assumes taxpayers have cash on hand or have credit and sustainable cashflow. Should the Biden-tax-era be short, this could work to bridge a gap, but should not be considered a permanent solution. Primarily, one must be mindful of the potential loss of step-up and potential for taxation of appreciation at death.

Bring on the S-Corporations, Maybe

S-corporations have historically provided a great vehicle for taxpayers to manage their own employment tax liabilities. For those active in their own businesses, the net investment income tax does not apply. So, how does this affect the other items?

First, the corporate tax is inapplicable to the S-corporation as income passes through to the owner. This means too that for certain taxpayers (those making less than $400,000), the 20% IRC Sec. 199A deduction may still be preserved as well. This strategy could mitigate the effect of the 12.4% Social Security payroll tax without increasing the other taxes. But, where things get interesting is how the S-corporation could be a vehicle for further planning.

One could consider the S-corporation a cellophane wrapper for income tax purposes. Unlike a partnership, the S-corporation ownership is purely an equity interest (i.e. capital in nature).[2] Specifically, when a partnership interest is sold (yes, this includes a limited liability company in many circumstances[3]), holding certain types of assets (inventory, accounts receivables, and certain types of depreciated assets), the result of the treatment of the sale may not be just capital in nature. To the extent those assets exist, and to the extent of the value attributable to the partnership interest sold, ordinary income is triggered in that respective amount with capital gains/losses trueing up the recognition on the sale.[4] The sale of stock would simply be a sale subject to capital gains. For those making less than $1 million (those with incomes over may have no benefit with capital gains being taxed at ordinary income rates), this means that a look through to the partnership’s “hot assets” (receivables, depreciation recapture, inventory, etc.) and therefore ordinary income rates, can be avoided upon disposition of equity interests. Further, this could make a significant difference upon equity interests passing at death as well should the tax on appreciation not be at ordinary income rates. At this point, it is still all speculation. Previously, we have concerned ourselves with the one-way street of taxation related to incorporation. By one-way street, we mean that taxpayers can contribute assets to a corporation on a tax-deferred basis. Coming out of the corporation is an entirely different story. Specifically, distributions of appreciated property are taxed as if sold when coming out of a corporation of any kind, S or C.[5]

It certainly seems that should Biden’s supposed tax proposals come to fruition S-corporations may become more prevalent than they are today. While not the subject of today’s article, discussions of S-corporation passive activities would become a lot more active because it may be that taxpayers would start sheltering assets in S-corporations to avoid the hot asset rule upon death (if such application of that rule were to ever exist).

So, in sum, the S-corporation could provide for some potentially helpful benefits:

  1. Mitigation of the 12.4% Social Security payroll tax;
  2. Circumvention of hot asset issues upon death; and
  3. Preservation (assuming income levels are met) of the 199A deduction by stretching out the gain after death.
Give (to Pay Less)

For now, it seems that the tax on unrealized appreciation occurs at death. With this in mind and step-up potentially off the table, it may be wise to consider gifting appreciated assets. This could be of value for many reasons. First, this plan could avoid the tax on unrealized appreciation at death. Just because there is a ton of unrealized appreciation, this does not mean that there is a market to sell the appreciated asset, a desire to sell, or the cash available otherwise to pay the tax. For this reason, I would be doubtful that such a law would pass. I would prefer to be careful as I have been surprised before.[6]

This gifting could get a double benefit. First, there would be a deferral of taxation on the unappreciated capital gains. Second, should exemptions ever go down, use of the higher exemption amount would be preserved.

Sell, Sell, Sell to Trusts (on a Note) (To Avoid Forced Future Sale)

Ok, so we all know what is going to happen, death and taxes. So, why pay today what you can pay…later?[7] If the estate and gift tax exemption is limited or gifting does not seem right at the time, sell to a trust, preferably (pending state tax considerations and unappreciated gain), to a grantor trust. The grantor trust would not result in any immediate income tax. Only the promissory note and unappreciated gain would remain in the estate. Even then, following death, gains might be able to be trickled out over time, being taxed upon eventual receipt of such payments, (1) delaying the tax obligations, and (2) potentially causing the gain recognized on each payment after death to be taxed at capital gains, thus possibly avoiding crossing the capital gains exclusion income threshold.[8]

In the interim, wealth is moved out of one’s estate tax-free to a large extent and hopefully the net taxable estate of the taxpayer would be further diminished. The taxpayer would also have the benefit of some cash flow from the note during the remainder of his or her lifetime. The note could be a long-term note. It is worth noting right now that the minimum required interest rates are at record lows. Once out of the estate, it may be possible for the unrealized gain to be deferred for an extremely long period of time, thus potentially addressing both the immediate taxation and the cash availability issues.

Don’t Forget the Life Insurance

Life insurance, previously a necessity for those with taxable estates and doubly so for those whose taxable estates consist of non-liquid assets, could become tremendously important again for the taxpayers of moderate wealth. Used properly, life insurance can be (1) outside of a taxpayer’s taxable estate (while also potentially diminishing a taxpayer’s estate during their lifetime), (2) a cash reserve to pay estate taxes, and (3) not subject to income taxation. With tax on unrealized appreciation and no step-up in basis at death being floated, life insurance certainly appears a lot more enticing.

Conclusion

While this article has been a thoughtful consideration of some “what-if’s,” it is important to remember that change is not immediately certain. Sure, change is inevitable and the pendulum will swing. But, until it does or until we are aware of impending and substantial change, it does not necessarily mean drastic actions should be taken now. Instead, the potential for change should be an indicator for people to review their current planning and assess their situation for the “what-if’s.” While we generally consider at least every five years (preferably two) to be a good rule of thumb to revisit estate planning, checking in more frequently when tax changes are anticipated is more sensible.

A few additional planning ideas during this favorable tax period are the following:

  • Defer loss realizations until higher tax years (again, could even consider the installment note sale if disposition is a must);
  • Accelerate gains during lower impact tax years;
  • Harvest capital gains for high income earners; and
  • Roth conversions.

The above aside, we still urge our clients not to plan based on political possibilities or rumors. Plan for today and plan well. A solid income tax and estate plan should have a reasonable level of flexibility to provide for some level of adaptation to change, whether it be more conservative in nature to mitigate taxes further or more opportunistic so as to take advantage of certain items like step-up. Regardless, one’s planning should be carefully considered, calculated, monitored, and finally, properly executed and administered.

[1] See https://taxfoundation.org/reviewing-joe-bidens-tax-vision/

[2] See IRC 751.

[3] Being an S-corporation tax status and a limited liability company are not mutually exclusive.

[4] Hot assets are a discussion all to themselves and are beyond the scope of this article.

[5] IRC 311(b).

[6][6] Noting that moment around 6:00 AM (Central Time) on November 9, 2016.

[7] See IRC 453.

[8] The assumption here being that hopefully the income threshold of $1 million would still apply and that the taxpayer would remain under this amount.

Joshua W. Sage, J.D., LL.M.

Josh is a partner at ESA Law. Josh practices in the areas of tax, business, and estate planning. View Full Profile.