Sign On
  • Online Banking
    Sign On Form is Loading

Now that Democrats control both the White House and Congress, significant changes to tax laws may be on the way.

Although the exact content of tax reform measures is uncertain, the pre-election proposals of the Democratic Party have a more significant impact on wealthy and highincome taxpayers.

Many experts and practitioners expect Congress to use a second budget reconciliation bill (requiring only a majority vote in the Senate to pass) later this year to enact the tax reform portion of President Biden’s legislative agenda. Rather than making the tax changes retroactive and potentially stalling the recovery, it appears likely that the effective date for the bulk of new tax provisions will be January 1, 2022.

Possible Tax Reform Measures

Dramatic and impactful changes may occur in the income tax arena and estate and gift tax laws. Some of the potential changes include the following:

  • Restoration of the 39.6% highest marginal rate (up from 37%).
  • Expansion of the 12.4% Social Security tax for wage earnings exceeding $400,000.
  • An increase in the long-term capital gains tax to 39.6% for taxable income amounts exceeding $1million.
  • Implementation of a carry-over basis regime at death (as opposed to step-up in basis) or a deemed income recognition event death for appreciated assets (income taxes due at death).
  • Establishment of a cap of 28% on the benefit of itemized deductions (including charitable gifts).
  • Reprise of the 3% PEASE limitation, progressively reducing itemized deductions for high-income taxpayers up to an 80% reduction of total itemized deductions.
  • An increase of the corporate income tax rate from 21% to 28% or higher and the phase-out of the 20% qualified business income deduction under new Section 199A for income over $400,000.
  • Reductions in the estate, gift, and generation-skipping transfers (GSTs) exclusions and exemptions. Prior Democratic proposals have variously advocated new limits of $5 million (indexed) or $3.5 million, a gift tax limit of $1 million, and/or a limit on the use of GST exemption of 50 or 99 years.
  • Modification of the grantor trust rules to cause estate inclusion of a trust to fall within the income tax inclusion rules of IRC Sec. 671 – 678.
  • Elimination or modification of some estate planning tax loopholes.

One potential tax change favorable to taxpayers (and possibly even retroactive) is eliminating the $10,000 deduction limit for state and local taxes (SALT). With Speaker of the House Nancy Pelosi and Senate Majority Leader Chuck Schumer coming from high-income tax states, eliminating this limit would be a welcome casualty of tax reform negotiations.

The 12 Steps to Take Now

Estate planning

  1. Utilize the generous $11.7 million gift/estate/GST exclusions or exemptions while they last. With several tax practitioners expecting the new legislation to become effective in the fall of 2021 or January 1, 2022, it appears that many high-net-worth taxpayers have one last bite of the apple to take advantage of the larger lifetime gift/GST exclusion.
  2. Consider intra-family loans and intra-family sales financed with promissory notes. Historically low Applicable Federal Rates (AFRs) permitted for intra-family loans make these arrangements advantageous to families interested in tax-efficient wealth transfers.
  3. Create asset protection trusts in 2021 before new laws establish more restrictive exclusions. A gift tax exclusion limit as low as $1 million can keep physicians and those in high-risk professions from creating asset protection vehicles even though their total wealth does not exceed estate tax thresholds.
  4. Work with clients to create a dynastic gift trust now, if applicable given their situation. Democratic tax proposals would subject assets in a trust to a GST tax every 50 or 99 years and cause the trust to be included in the settlor’s estate if that trust falls within one or more of the income tax provisions for grantor trusts. Many installment sales of business interests involve tax-advantaged dynastic trusts. If these trusts are established before the law changes to make grantor trusts includible in a settlor’s estate, the trusts could be grandfathered and spared from any adverse tax consequences.
  5. Balance assets between spouses. Balancing assets between spouses to ensure optimum use of GST exemption if the less-propertied spouse passes away first can reduce estate taxes at the children’s level and maximize wealth transfers to younger generations.
  6. Consider a donative promise to lock in higher exclusion amounts if it is not practical to gift assets. Many advisors believe that taxpayers can make a substantial gift utilizing their exclusion without actually parting with any assets. The strategy involves a promise, legally enforceable under state law, to make gifts to a donee in the future. For federal gift tax purposes, the promise will be treated as a gift when the promise is made rather than when it is paid. Thus, the taxpayer can take advantage of the larger gift tax exclusion amount available at the time of the promise.
  7. Review estate planning savings techniques being employed within your plan, if you are concerned about retroactive law changes. These include creating disclaimer language in a trust to undo a gift and using a qualified terminable interest property (QTIP) election where appropriate to qualify for the unlimited marital deduction rather than using the gift exclusion.

Income tax planning

Follow the general rules of thumb when income taxes are expected to increase. Taxpayers should consider:

  1. Accelerating income. This could include converting a traditional IRA to a Roth IRA, harvesting capital gains in 2021 rather than 2022, relocating an IRA, and accelerating billing and fee collection in December 2021 for cash-basis taxpayer businesses.
  2. Deferring loss harvesting and expenses. However, with itemized deductions (including charitable donations) possibly limited to a 28% benefit in the future, accelerating some deductions in 2021 may prove advantageous.
  3. Pay state and local taxes in 2022. Since the lifting of the $10,000 SALT limitation is one change that may benefit taxpayers, the timing of these payments may be critical. Taxpayers may want to delay the late-year payment of property taxes and state and city income tax estimates until January 2022 if the tax savings outweigh any late payment penalties.
  4. For S corporation owners, increase distribution and decrease salary (within reason). Faced with a future increase in Social Security taxes, an S corporation shareholder may want to increase corporate dividends/ distributions (which are not subject to payroll taxes) and limit wages to $400,000, or an amount that satisfies the “reasonable compensation” tests.
  5. Revisit portfolio management strategies regarding invest-and-hold decisions and diversification. One of the most significant tax proposal components is the elimination of the preferential rate for long-term capital gains and qualified dividends on income over $1 million.

This would amount to a near doubling of the tax rate on long-term capital gains from 20% to 39.6%. Portfolio management strategies regarding invest-and-hold decisions and diversification may need to be adjusted.

If a step-up in basis at death is retained, many taxpayers may feel compelled to hold assets until death. However, their investment advisors may want to:

  • Identify concentrations and overweight positions to sell in 2021 and diversify out of those positions now.
  • Manage gain recognition each year to ensure that less than $1 million of income is recognized, so long-term gains are not taxed at 39.6%.

If unlimited step-up in basis at death is repealed or if the law invokes a deemed recognition event for appreciated assets at death:

  • Taxpayers will find more incentive to recognize gain during life to diversify investments and de-risk portfolios. It is unclear if some limited step-up in basis will be allowed or if there will be some exclusion to a deemed disposition at death system. In 2010, when estate taxes and the unlimited basis step-up were suspended, taxpayers were allowed a $1.3 million basis step-up and an additional $3 million basis step-up for assets passing to a spouse. Accordingly, retaining some level of appreciated assets until death may still be advantageous. Under a deemed disposition at death system, it is not clear how deductions will work to avoid double taxation.

Other Critical Estate Planning Considerations and Caveats

Married taxpayers who are considering two $10 millionplus gifts to take advantage of this planning window before it closes must be mindful of several things. It can be challenging to structure two large, non-reciprocal spousal trusts (e.g., SLATs) within a compressed timeframe.

Taxpayers must also keep ordering rules in mind when an exclusion is used. Since taxable gifts entail using the old exclusion first, it will save significant taxes if one spouse creates a single $11 million SLAT gift rather than creation by each spouse of a $5.5 million SLAT.

Also, there is the issue of premature death of a SLAT’s beneficiary spouse. By their very nature, tax-mitigation SLATs entail large gifts. There is a risk to the donor spouse losing indirect access to the gifted wealth if the beneficiary spouse dies prematurely. Insurance on the beneficiary spouse’s life can alleviate that risk.

Other factors and prospective tax changes are making 2021 an opportune time for estate planning. The value of assets may be suppressed, particularly closely held businesses impacted by the pandemic. Since valuation discounts have been targeted by Democratic tax proposals and proposed Treasury regulations, 2021 may be the last year to employ tax-efficient wealth transfer techniques for business interests leveraging discounts for lack of control and lack of marketability.

Consider Charitable Remainder Trusts in a High Tax-rate Environment, Particularly for Sales Of Appreciated Stock and Business Assets

The long-term capital gains tax rate may be increased from 20% to 39.6% on large transactions. Compared with an outright sale of appreciated stock, the tax-deferral benefits inherent in a charitable remainder trust (CRT) increase exponentially with higher tax rates. Rather than recognizing all the gain in one year and likely exceeding the $1 million threshold for the 39.6% rate, a CRT allows a taxpayer to avoid gain entirely in the year of the sale and spread the gain over their lifetime. This would make it easier for the annual income to fall within the $1 million limit and the 20% tax rate.

By later establishing residence in Florida or another state without an income tax, a taxpayer in a state with a high income tax at the time of selling appreciated assets could further increase the tax-deferral benefits of a CRT.

One caveat: If the sale of appreciated assets could occur in 2021 at a 20% rate, a sale outside the CRT may be the preferable course. Although the CRT would defer gain, it would defer the gain from a 20% capital gain year to a 39.6% tax environment going forward

For more information, please contact your Key Private Bank Advisor.

Publish Date: April 13, 2021.

Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

KeyBank does not provide legal advice.

Investment products are:

NOT FDIC INSURED NOT BANK GUARANTEED MAY LOSE VALUE NOT A DEPOSIT NOT INSURED BY ANY FEDERAL OR STATE GOVERNMENT AGENCY