It is difficult to predict what will happen in this November’s Congressional and Presidential elections, but we know the impact could be significant. With the Presidential and the Senate elections in a tight battle, the pendulum of power may swing. If the Democrats get the trifecta of taking the Senate and President’s seat while retaining the House, tax legislation is one area that a new administration may pursue early in the term.
If President Trump were re-elected and the Congressional makeup was favorable for the Republicans passing tax legislation, previous comments by that party have signaled that they would like to extend the provisions of the Tax Cut and Jobs Act of 2017 (“TJCA”). President Trump will likely reveal his proposals as the election season begins. For now, however, let’s take a look at potential tax law changes if a new administration were to take office. Note that when we refer to Former Vice President Biden or a Biden administration, we generally mean the Democrat party or the Democrat-led Congress as Congress is the body that initiates legislation.
Marginal Tax Rates at the Higher End May Increase
Biden has proposed increasing the top marginal tax rates to the previously high amounts of 39.6% (pre-TJCA law) from its current level of 37%. Currently, the 37% tax rate is legislated to increase to the 39.6% in 2026 (under the sunset rules of the TJCA). The marginal tax rate is the tax rate on which the next dollar is taxed. As of 2020, the highest rate applies at an income tax base of $518,401 for single filers and $622,051 for joint filers. Such income thresholds would likely be slightly higher in future years due to inflation adjustments.
While this won’t impact many, this will impact many professions we work with, including surgeons, senior executives, and business owners. While you are likely already taking proactive steps to minimize your income tax hit if you are in the 37% tax bracket, you should nevertheless revisit whether you are maximizing your contributions to retirement plans, health savings accounts, and other tax deferral opportunities. As noted in the social security tax section, there may be opportunities to time your income and deductions to correspond with years in which your marginal tax rates may be higher or lower, depending on your objective.
Cap on Itemized Deductions
Biden has also proposed a cap on itemized deductions at 28% as well as bringing back the Pease Limitations for itemized deductions. While many taxpayers no longer itemize deductions in light of the tax legislation that significantly increased the standard deduction amount, this law will still impact many taxpayers – especially those in higher income tax brackets. This rule basically says that even if you are in the top tax bracket of 39.6% (proposed), you would only get a deduction of 28% of the itemized deductions. Common itemized deductions include charitable contributions, state and local taxes, and mortgage interest expense.
The Pease limitation, one of Congress’s finest pieces of work in an effort to make the tax code more complex, generally reduces the amount a taxpayer can deduct for certain itemized deductions if their income is above a certain threshold. While the Pease Limitation was scheduled to be reinstated in 2026, Biden would accelerate its application for those with income above $400,000. It is likely that this threshold would be lower for Single filers as was the case under previous law, but the details were not known as of the publish date. The previous threshold was $313,800 (2017) for taxpayers that filed Married Filing Jointly.
If you are a taxpayer that would be impacted by this, you may want to revisit your charitable giving measures. You may want to accelerate your charitable giving to a year in which the Pease limitation did not apply – either because the law was not in place or because your income did not exceed the applicable threshold. Of course, we gift for non-tax reasons primarily so don’t let the tax impact negate your ability to positively impact your favorite charity’s mission.
Impose the 12.4% Social Security Tax on Earnings Over $400,000
Currently, the Social Security Tax (“SS Tax”) is capped on wages up to $137,400. While the Medicare Tax of 2.9% applies to an unlimited amount of Wages, the higher SS Tax of 12.4% is capped as noted. The employee’s share of this tax is one-half of this amount or 6.2%. Thus, there would be a donut in which the SS Tax would not apply (between the lower limit of $137,400 and the upper limit of $400,000).
For those making considerably over the $400,000 threshold, this tax can be quite a hit. There may be some strategies to consider, but deferring more to retirement plans is not one of them. Saving to a Health Saving Account should already be on your agenda, but if you are not currently doing this, this extra tax hit may encourage you to take advantage of this.
If you are a business owner, this change in the tax code could impact the type of business entity that is preferred. If you are operating as an LLC (or sole proprietorship), then all of your net profits are generally considered earnings. Contrast this with an S corporation in which you can declare a certain amount to be wages (as long as it meets the definition of “reasonable”), allowing the remaining part of your net business earnings to potentially be deemed wages and thus escape that additional SS tax. State law – tax and non-tax -- should also be considered, obviously, in choosing the entity that is right for you.
Other ideas may include accelerating income in years in which your effective tax rate may be lower or pushing deductions in years in which your tax rate may be higher.
Increase Capital Gains and Dividends Tax Rates for High Income
Biden has proposed increasing the capital gains tax rates and dividends tax rates to 39.6% for those with income over $1,000,000. Currently, such rates are at 20% (and 15% for us commoners) plus the 3.8% net investment income tax, when applicable. While this will not apply to many taxpayers, this is a significant increase. Rather than paying a top rate of 23.8%, high income tax payers may now be faced with a federal tax rate of 43.4% (39.6% + 3.8%).
For those business owners that are looking to sell their business in the near future, this possible tax change should not be taken lightly. After all, when selling a business, the key is not merely focusing on what you gross – the more important figure is the net amount that you keep after taxes (and lawyer fees). If you are not preparing to sell your business in 2020 as of right now, it may likely be too late to launch a successful campaign to sell your business. Nevertheless, you may want to think hard about the timing of your sell and the myriad of steps you need to take to get your business ready to be sold. Again, we should never let the tax impact control the timing of an asset – especially one that is so near and dear to us as our business; however, taxes are a factor in making these decisions.
Similarly, those executives that hold substantial concentration in public stock should revisit their decision on when to retain the stock. (Too many executives hold onto stock because they just hate paying taxes. Not only do they take on “uncompensated” concentration risk, their reluctance to sell may cause them to be in higher tax brackets when the winds of tax law changes blow through.)
Charitable planning may also take on added importance. While utilizing the plain vanilla strategy of gifting appreciated assets (rather than cash) to charity could be effective, more advanced strategies that lost their luster a bit may come back into vogue. Those with significant capital gains and a charitable bent may wish to discuss with their advisor whether a charitable remainder trust may be advantageous for their situation. Of course, one needs to be cognizant of other tax law changes that would impact various strategies, including the Pease limitation mentioned elsewhere.
Phase-out of the Qualified Business Income Tax Deduction
Currently, owners of pass through entities (sole proprietorships, LLCs, S corporations) can deduct 20% of their qualified income (“Qualified Business Income”) through 2025. While there are more detailed rules on when this deduction can be made and certain high-income taxpayers may already be phased out in taking this deduction, Biden would eliminate that deduction for all of those with income over $400,000.
With a threshold of $400,000, some taxpayers will want to look at their situation on a multi-year basis more than ever. Timing the recognition of income or expenses may be a profitable strategy. Such business owner taxpayers may plan their affairs to get the benefit of the deduction one year while not qualifying for it in alternating years. This could also impact the choice of entity considerations as well as how and when to make retirement plan contributions.
Expand the First-Time Homebuyer Tax Credit
Not all of Biden’s proposals are aimed at increasing taxes on high income taxpayers. He has proposed reinstating and increasing the first-time homebuyer tax credit. While all of the details have not been offered, he has proposed a credit of $15,000. As you may recall, the 2008 – 2010 version of the first-time homebuyer tax credit was $7,500 to $8,000, and the application of the credit varied based on the time when the house was purchased. In some cases, the credit has to be repaid (what kind of credit is that?) while in other years there was no repayment requirement. The previous law also had income eligibility requirements. Single filers generally had to have income less than $95,000 and joint filers had to have income less than $150,000, but these levels increased in the later years of this credit.
It will be interesting to see, if such legislation is indeed proposed, what the details will consist of. It begs the question – and I think it is a legitimate question – do first-time homebuyers hold off on buying homes in 2020 with the hope that they can potentially get $15,000 as a credit? (Note that this credit would likely be a “refundable” credit, meaning that the taxpayer would get the full amount in cash money regardless of his or her tax liability.)
Again, the tax treatment should not be the only factor in making the decision. The risk of waiting to buy a home for several months or a few years is the potential increase in interest rates. At near historical levels, the current interest rate environment makes buying a home currently more appealing. However, I am curious about the impact of housing prices due to both the lower interest rate levels and the credit. One would think it impacts the values of homes since the demand is impacted. Regardless, if the credit is indeed $15,000, is refundable, and if one has income below the threshold, this tax law may impact one’s timing on buying a home. Moreover, these taxpayers may need to do some multi-year tax planning (i.e., time the recognition of income and/or expenses) to qualify for this credit at the appropriate time.
Note that under the previous credit taxpayers were required to stay in the home for three years.
Related to the credit, Biden has also proposed a refundable tax credit for rent and utility payments for low income taxpayers. The idea is to hold rent and utility payments to 30% of income. We have not seen details on such proposals, but, if enacted, this could provide nice opportunities for low income taxpayers. Note that this could even apparently apply for those retirees that may have substantial assets, but are able to keep their income low during the “tax planning window period”, i.e., between retirement and the date one has to start taking social security and/or retirement plan distributions.
Retirement Plan Contributions
There was reference on Biden’s campaign website to “equalize the benefits of defined contribution plans” so that low- and middle-income taxpayers can get an equal benefit as that of higher income taxpayers. One would speculate that this would equate to a tax credit – rather than a deduction - for such contributions. Stay tuned for this as this could provide some nice tax savings. Depending on where one’s income falls, there will likely be a need to shift income and deductions around to maximize this benefit.
Related to this, there is a proposal to provide an incentive for small businesses to receive a credit to offset the costs of administering a 401(k). Similar legislation was included in the SECURE Act of 2019 so perhaps this increases the amount of the credits for small business. Also, there is mention of an “automatic 401(k)” so that employees can save more to retirement plans. It will be interesting to see the details of this proposal. Perhaps a 401(k) may become the retirement plan of choice for even small businesses. Currently, SEPs and SIMPLE IRAs are often desirable choices for small business retirement plans, but they come with certain limitations. Small business owners should stay abreast of any potential changes in this arena and have discussions with their advisor about the ideal type of plan for their business and employees.
Estate and Gift Tax and Step-Up in Basis
Biden – as documented in the Biden-Sanders Unity Task Force Recommendations released in July, 2020 -- has suggested that he thinks estate taxes should “return to their historical norm”. It is uncertain what this exactly means. There have been several bills proposed recently that provided for a variety of measures, including reducing the exemption to $3.5 million so it may be along those lines. Other members of the Democrat party such as Senator Elizabeth Warren have proposed the estate tax exemption be lowered to $1 million. (The amount of the exemption means that a husband and wife can leave $1 million each to their heirs without having to pay federal estate taxes.)
Currently, the estate tax is a whopping $11.58 million (due to the TJCA). While it is unlikely that any party will push or be successful in reducing the exemption all the way to $1 million, it will be interesting to see if the exemption is reduced from its $11.58 million amount. Currently, that higher amount of $11.58 million is legislated to revert to $5 million (adjusted for inflation which may put the exemption around $6 - $7 million when 2026 arrives). Since the Democrats referenced the desire to “address the extreme concentrations of income and wealth inequality”, I don’t think changes to the estate tax laws should be ruled out.
Other than the “George Steinbrenner home run” strategy of passing away when the estate tax laws are favorable (in 2020?), we would suggest you sit tight and evaluate the impact of the changes as they occur. Not only will the estate tax laws impact one’s estate tax situation, but the estate tax laws may also impact how assets are divided amongst heirs or trusts since many wills or trusts reference the estate tax exemption when distributing assets.
Related to the estate tax, however, is the step-up in basis rule. Current law allows for individuals to receive a step-up in basis for assets owned or deemed owned at death. (This rule does not apply to certain assets such as IRAs, 401(k)s, or annuities.) This step-up rule can provide significant tax savings for many taxpayers’ families of moderate wealth. Biden and prior administrations have proposed getting rid of the possibility of step-up. The ultimate proposal may include death as the trigger of the capital gains recognition; alternatively, the proposal may include a carryover in basis to the heirs for the heirs to ultimately be taxed on the sale.
If this law were certain to happen, one may try to plan the timing of the sale of appreciated assets in order to minimize income taxes or engage in a variety of charitable planning techniques. However, since any legislation such as this is uncertain (and somewhat unlikely in that it has been previously proposed on several occasions), we recommend sitting tight and not letting the potential tax changes impact whether you should sell certain assets.
Other parts of Biden’s proposals include increasing the tax rate that C Corporations pay to 28% (from 21%) and limiting the ability to do like-kind exchanges.
As with all potential legislation, nothing is certain until it is passed. More significantly, it is still uncertain what party may prevail come November. There is certainly a chance that the various branches may be split parties, resulting in more haggling and less action. Nevertheless, despite this uncertainty, it is critical to stay abreast of potential tax law changes and evaluate how it relates to your situation. Don’t let the tax laws control your choices, but do consider taxes as one factor in your decision-making process. Of course, if you need help navigating taxes and your overall retirement situation, please do not hesitate to reach out to Oasis Wealth to begin (or continue) the conversation.