I did not mean to start this blog blast like a Lemony Snicket novel, but September could prove to be a Series of Unfortunate Events, especially for those in the tax field.
We're often amused by how some of the press likes to overhype certain policy developments. No matter how insignificant the issue, we're always "barreling" toward some benign deadline. However, policy developments are likely to play a big role in financial markets over the next couple of months. Congress will likely pass Biden's economic plan over the next few months, with significant implications for taxes, infrastructure, and alternative energy. We've been skeptical Congress will meaningfully transform the role of government in the economy and society, but the odds of that are growing.
Even under a compromise scenario, tax increases will be the largest since 1968 and nearly three times the size of the tax increases enacted by Reagan, Bush, Clinton, and Obama. This will be the first time Congress will raise corporate taxes and capital gains taxes in the same legislation since the early 1950s. Some investors believe the tax increases are manageable. They could be with an accommodative Fed, but what we are doing is outside the normal range of nearly every professional investor's lifetime.
Next week will be a big week – the Senate Finance Committee is looking to present their legislation on Monday. So, the big question is: When Could a Bill Be Finalized? Historically speaking, the average number of days from a budget reconciliation passing into a complete legislation package is, on average, 59 days. The budget reconciliation passed the House in mid-August. Using historical averages, we could see a bill enacted sometime in October.
I released some Capital Gains commentary earlier in the week – we had a lot of positive feedback. Given that, let's delve into some of the remaining tax issues that could affect your clients.
1. Estate Taxes
2. Gift Taxes, and
3. "SALT" Deductions
Again, a disclosure - everything that I'm talking about continues to be an evolving situation, i.e., this blog post could be obsolete within a day. So, the Date of Publication is 9/14/2021.
Reminder, gift taxes, and estate taxes are connected - gifts made during your lifetime will reduce your taxable estate. However, gifts over the annual exclusion also reduce your estate tax exemption. Bottom line, making yearly gifts up to the exclusion ($15,000 in 2020) is an excellent way to reduce your taxable estate without any adverse side effects.
Current Estate Tax Law:
Threshold: The current estate, gift, and generation-skipping transfer ("GST") tax exemption are $11.7 million per person, with a top tax rate of 40%, which is set to "sunset" at the end of 2025 to pre-2018 levels - approximately $5.6M (adjusted for inflation).
Step-Up in Basis: Upon death, certain assets receive a "step-up" in cost basis, meaning its basis becomes its value at death. This can result in the elimination of taxable gains on inherited assets.
Estate Tax Rate: 40%
Proposed Estate Tax Change:
Threshold: Reduction of the estate and gift tax exclusion currently at $11.7 million to $3.5 million
Step-Up in Basis: The proposed rule would mandate that the heirs take on, or 'carryover,' the decedent's basis.
Estate Tax Rate: 45%
Commentary: I expect the estate tax rate to be lifted and the exemption to be lowered. Note that this is very different than what Biden proposed. Biden has proposed moving from a step-up in basis to a carryover basis and imposing a new unrealized capital gains tax at death for gains over $1mm. Both ideas are not getting the traction needed to pass a narrowly divided Congress. We've heard some talk that Congress may insert the Biden proposals but have them kick in five years from now. This is a way of using the revenue for spending but not dealing with the changes immediately. As such, we are not discounting the Biden proposal, but it is less likely to impact the short-term if anything.
Current Gift Tax Law: The annual federal gift tax exclusion allows you to give away up to $15,000 in 2020 to as many people as you wish without those gifts counting against your $11.7 million lifetime exemption.
Proposed Gift Tax Changes: Starting in 2022, the act would reduce the annual exclusion to $10,000 per year/per donee and limit the donor to $20,000 annual exclusion gifts in total. These limits will significantly restrict an individual's ability to make gifts without using their lifetime exemption.
Commentary: Pretty simple here, but, luckily, the IRS has confirmed that it will not claw back tax on lifetime gifts if the exemption is subsequently lowered.
Current SALT Deduction Law: Starting with the 2018 tax year, the maximum State and Local Tax ("SALT") deduction became ~$10,000. There was previously no limit. This left some high-income filers with a higher tax bill. The limit is also essential because the 2021 standard deduction is $12,550 (for single filers). So, you need to have another $2,550 of itemized deductions beyond the SALT deduction to itemize.
Proposed SALT Deduction Change: An increase or elimination of the State and Local Tax Deduction.
Commentary: An elimination or increase in SALT is quite likely. First, this is an essential aspect of the bill for Speaker Pelosi (CA), Senate Majority Leader Schumer (NY), and the moderate Democrats in higher-income districts worried about voting to raise income and cap gains and estate taxes on their constituents. Secondly, eliminating SALT would reduce taxes for the wealthy, which would be aesthetically wrong for the democrats.
Much like the previous blog blast, we do not believe that tax considerations should be the driving force behind investment decisions. However, understanding tax implications is essential in optimizing your family wealth. Please consult me or your tax accountant with any specific questions.