Author – Peggy Lennon
President Biden has introduced the American Families Plan (“AFP”), advancing the administration’s infrastructure agenda. As drafted, the AFP includes $1 trillion in investments and $800 billion in tax credits aimed towards children and families. The AFP adds funding for the expansive agenda by tax increases, which are aimed at wealthy taxpayers, to be backed by increased IRS enforcement. This post focuses on the tax changes rather than the anticipated initiatives.
There are some tax benefits for families with children and low-income taxpayers. The AFP would extend the American Rescue Plan’s increase in the child tax credit to $3,000 ($3,600 per child under six) from $2,000 per child through 2025 and make it fully refundable. In addition, it would permanently extend the American Rescue Plan’s expansion of the child and dependent care tax credit. Finally, the Earned Income Tax Credit Expansion for childless workers would be made permanent.
Let’s look at some of the revenue raisers:
- The top marginal income tax rate for individuals would be 39.6%, instead of 37%, restoring the pre-2017 top rate.
- The qualified dividends and capital gains rate would increase to 39.6% (from 20%) for households making more than $1 million per year, effectively taxing such gains at ordinary rates (for a total capital gains rate to 43.4% when the 3.8% Medicare tax applies).
- The threshold for the application of the 3.8% Medicare tax would be raised to taxpayers earning more than $400,000 (up from $200,000 for single taxpayers), along with an expansion of its tax base to include gross income and gain from any trades or businesses not otherwise subject to employment taxes. In addition, employment taxes under SECA will apply to the distributive shares of S corporation shareholders, limited partners and LLC members who provide services and materially participate in the entity’s trade or business, to the extent that this income exceeds certain threshold amounts.
- Real estate like-kind exchanges would not protect gains greater than $1.000,000 per year.
- Income and gains received from carried interests be taxed as ordinary income.
- The limitation on excess business losses of noncorporate taxpayers under Sec. 461(l) would be permanently extended, following a suspension of this limitation for 2018, 2019 and 2020 under the CARES Act.
- Transfers of appreciated property by gift or on death will be treated as realization events, resulting in income (typically capital gains) to the donor, including transfers to an irrevocable “grantor trust.” The “step-up” in basis for inherited assets would be limited to protecting gains of $1 million per person ($2.5 million for a married couple including the existing exclusion of $500,000 of gain on sale of a principal residence). Special rules would apply to family-owned businesses or farms that are passed on to heirs who continue to run the business, and exceptions for spousal transfers and charitable contributions would apply, although split charitable interest gifts, such as charitable remainder trusts, would be affected. As to any property acquired after 1/1/1940, gain on unrealized appreciation would be recognized by a trust, partnership, or other noncorporate owner if that property has not been the subject of a recognition event within the prior 90 years, with the earliest possible recognition event occurring on December 31, 2030.
If the above changes become effective for 2022, traditional year-end income tax planning will take on increased significance. Consideration should be given to accelerating income and gains into 2021 in order to take advantage of low tax rates (if applicable) and delaying deductible expenditures and losses to the following year, when the increase in rates makes those reductions to income more valuable. If a Roth conversion or Section 1031 exchange is under consideration, 2021 may be the better year to undertake this transaction if the above changes become law. Finally, the proposed elimination of the basis adjustment at death would turn traditional estate planning on its head and the use of grantor trusts will be significantly curtailed.
In terms of increased enforcement, the AFP would do the following:
- The IRS would receive additional funding over the next ten years to increase enforcement activities aimed at wealthy individuals (those making more than $400,000), estates, businesses, and large corporations.
- The IRS would also benefit from expanded authority to regulate tax preparers.
- To bolster the enforcement ability of the IRS, financial institutions will face new requirements to report information to the IRS on account flows related to investments and business activity. This will increase IRS visibility into investment and business activity based on account balances, inflows, and outflows from financial accounts.
- The IRS will also benefit from infrastructure upgrades to its antiquated systems.
Anticipated Changes Not (Yet) in the AFP
So far, the AFP has not addressed lowering estate tax exemptions or increasing estate tax rates, a position favored by President Biden on the campaign trail. However, it remains to be seen whether parts of other proposed bills will be woven into the AFP, as needed to close funding gaps or attract votes from individual legislators. Under the “For the 99.5 Percent Act” proposed by Senator Sanders, the lifetime exemption would fall to $3.5 million and estate rates would become more progressive with a top rate of 65% (which would become the tax rate for transfers subject to the generation skipping transfer tax). In addition, this legislation includes initiatives, long favored by Democrats, limiting popular tax planning techniques, including lifetime gifts, annual exclusion gifts, grantor retained annuity trusts (GRATs), valuation discounts, dynasty trusts, and grantor trusts (and related uses such as sales to defective trusts and life insurance trusts). Senator Van Hollen’s Sensible Taxation and Equity Promotion (STEP) Act would tax unrealized capital gains at death or when gifted, subject to a $1 million exemption per person, some or all aspects of which appear to be part of the AFP as discussed above.
Any of the above changes would significantly impact future estate tax planning (and some existing plans). Planning for these initiatives is not for the faint of heart, as it could involve use of current exemptions, locking in discounts, taking advantage of GRATs, and so on, with careful attention to the proposed effective dates, while keeping an eye on the income tax changes that can make gifting less attractive in the long run.
One hoped for item is thus far not in the cards. Californians will presumably need to live with the limitations on the deduction of state taxes imposed as part of the 2017 tax legislation.
Much Remains to be Seen
The AFP has met opposition from legislators, both Republican and Democrat, who seek to scale back (or expand) some of its initiatives or the tax changes. Moreover, the adoption of the AFP in its current form does not mean that progressive politicians will not continue to seek an expansion of the estate tax or other tax reforms. Significantly, the effective dates are not yet known, and while the law typically favors prospective tax legislation, it will be important to continue to monitor the legislative process.
By Peggy Lennon