Wealth Planning and the Biden Administration: What to Expect and Do When You’re Expecting … Changes to the Tax Code

Senior Wealth Planners Ali Hutchinson and Stacia Kroetz look at potential changes to the tax code under the Biden administration and explore tax planning considerations most relevant to our readers this year.

The Biden administration has promised to press for significant revisions to the tax code. So far this year, the executive branch has asked for legislators to draft “big” and “bold” proposals, which could mean sweeping changes to the estate, gift, income, corporate, capital gains and other transfer tax rules, regulations, rates and exemptions. Here, we try to make sense of the potential changes and explore tax planning considerations most relevant to our readers this year.

First, a quick recap of 2020. Flexibility was the theme of the year, because people were doing a lot of tax-expedited planning and wanted the ability to shift funds to other beneficiaries or revisit planning down the road. The question on the mind of many of our clients was: How can I use available tax exemptions, but also maintain some kind of access to those funds?

We saw a few types of trusts used again and again. The first by a landslide were spousal lifetime access trusts, or SLATs, which permit one spouse to access funds set aside by the other, while still using that spouse’s transfer tax exemptions and moving the funds out of the taxable estates of both spouses. Clients also set up vehicles such as dynasty trusts, generation-skipping transfer trusts and a few self-settled asset protection trusts, which are a special kind of trust that can allow the person who funds the trust to eventually be its beneficiary in some situations. We also saw clients forgive family loans and make outright gifts to adult children or grandchildren. Many were philanthropic, taking advantage of some of the tax benefits – and obviously, public health benefits – to giving to COVID-19-related charities.

Ali Hutchinson: Stacia, looking ahead at 2021, walk us through this talk of a “blue wave.” There are (albeit slim) Democratic majorities in the House and Senate, and Democrats have moved into the White House. Is this administration just going to pass whatever it wants as quickly as possible?

Stacia Kroetz: Probably not. As we know, there’s now a 50-50 split in the Senate. If there’s a need for a tie-breaking vote, that vote is cast by Democratic Vice President Harris. That may sound like the Democrats can push through any policy they like, but it may not be that simple. This wasn’t the blue wave that many people were expecting, and a few centrist Democrats have said they won’t just vote for anything the Democrats put forth. So the policies presented, and the laws that are ultimately passed, may end up being less extreme than President Biden had initially discussed on the campaign trail.

AH: Right – I’ve heard Sen. Schumer’s job described as corralling 50 frogs into a wheelbarrow and saying, “No one jump!” As difficult as that will be, especially with the centrist Democrats you mention, let’s assume he might be able to keep everyone in the wheelbarrow on some issues. What happens then? Remind me briefly how laws usually get passed, and if it’s not going to go that way, can you give us a brief understanding of what the budget reconciliation process looks like?

SK: The standard process to pass a law requires a supermajority of 60 votes in the Senate. It seems unlikely that this path will be successful given that it would require favorable votes from at least 10 Republicans. That’s why we’ve been hearing about the budget reconciliation process, which is the second option. Reconciliation bills can be passed with a simple majority of 51 votes and are not subject to filibuster, so the process can be a very attractive, albeit somewhat complicated, way to get bills through Congress.

AH: When it comes to more divisive areas like tax policy, it sounds like we’re going to be looking toward this reconciliation process. The biggest question our clients have relates to timing. Is it too late to act? Walk us through the options.

SK: There are two points in time that we need to be concerned about. The first is when a law will get passed, and the second is the date the provisions of that law will go into effect. In terms of when it will get passed, many commentators are speculating on whether anything will actually happen on the tax front in 2021 given Biden’s focus on getting the coronavirus under control, social justice concerns, environmental concerns and so forth, in addition to the process it would take to put a bill together and get it passed, even through the reconciliation process. Our best guess is that if tax reform is on the agenda in 2021, it probably wouldn’t be until the second half of the year.

Having said that, there have been some reports recently that the Democrats may add some tax changes to their proposed COVID-19 package, so we’ll be keeping an eye on that.

AH: Thinking about this “big, bold” legislation, or maybe some tax legislation snuck into a COVID-19 package, how does that work? Would the changes be retroactive? When should we do something, if anything, and what are the options?

SK: The collective wisdom of the legal and tax community is that it’s unlikely, but not impossible, that the changes would be retroactive. The Constitution doesn’t specifically prohibit it, but it also doesn’t specifically allow for it. For a retroactive change in the law to be respected, it must be rationally related to a legitimate legislative purpose. Arguably, raising revenue in the midst of a pandemic with historic bailout packages would seem sufficient to meet this requirement – but again, unlikely.

For the purpose of understanding what the consequences might be, let’s work through an example. If there was a retroactive change to the lifetime exemption amount, there could be a 40% (or higher) tax due on a gift made in excess of the new exemption amount. In other words, if you make a gift now of the available exemption amount of $11.7 million, and a law is passed sometime this year that reduces the exemption amount to $5 million and is effective retroactively as of January 1, 2021, then you could theoretically be stuck with a gift tax bill of over $2.5 million. Clearly, the consequences of a retroactive change would be significant – but again, it’s unlikely. The exemption amount for gift and estate tax purposes has never been decreased retroactively before and, in fact, has never gone down at all.

AH: We don’t have a lot of control over something that’s retroactive, so our focus here is going to be on whether there is some planning that we can implement now. Can we take a break and wait until 2022, or are there things that we should be doing as soon as possible?

SK: The answer to your question as to whether we have until 2022 is maybe. Rather than a retroactive change, it’s more likely that any tax policy legislation would be effective as of a certain date in the future, as is often the case, or as of the date that the law was proposed. Legislation can be made effective as of the date proposed when revenue may be at risk by having a period of time between the proposal and the enactment of that law. For example, the argument may be made that as soon as a change in the exemption amount is proposed, wealthy individuals will run and make gifts, and that would put revenue at risk and (at least partially) defeat the purpose of the legislation.

The option of the effective date being the date that the law is proposed still makes planning a bit difficult, so if you are planning to do some estate tax planning this year, we suggest you get in front of your lawyers sooner rather than later to think through your options. I would add that as a general matter, we think the only place that taxes are likely to go is up, at least in the near term. There’s a lot of COVID-19 relief being planned, and it has to be paid for from somewhere.

AH: Knowing that there are many, what are the changes to the tax code that we are most concerned about on behalf of our clients who are predominantly high-net-worth business owners and families?

SK: We’ll start out with the ordinary income tax rate. Biden wants to increase the tax rate for those earning an annual income of over $400,000 to 39.6% (up from 37%). So, if you’re a business owner and have control over the timing of income for you and your employees, you may want to consider paying bonuses or other forms of ordinary income in 2021, rather than 2022. Next is the rate for long-term capital gains and qualified dividends, which is currently 20%. Biden’s proposal is to tax long-term capital gains and qualified dividends at ordinary income tax rates for those with taxable income over $1 million, so potentially up to 39.6%. Given the significance of this potential change, our clients may want to consider their options for mitigating its impact. For example, if you’re a business owner with built-up cash, you might want to pay a dividend in 2021 rather than 2022. Or if your family has legacy holdings with significant built-in capital gains, you might want to consider realizing those gains in 2021.

AH: Let’s talk about the state and local tax cap. Will we see a change there?

SK: Under current law, the deduction is capped at $10,000 through 2025. Biden has not given a clear indication of his position on this subject, but he would likely be in favor of repealing the cap. It doesn’t seem like something he would focus on immediately, but may instead end up being part of a larger package.

AH: The changes that get the most press in our world are the estate and gift and generation-skipping transfer tax provisions. Talk about what you’ve heard in terms of the proposals around those changes and what people are doing now.

SK: The current gift and estate tax rate is 40%, and the current exemption amount from gift and estate tax is $10 million (adjusted annually for inflation), so for 2021, that’s $11.7 million. That exemption amount is currently scheduled to sunset back to $5 million (adjusted annually for inflation) at the end of 2025. Biden hasn’t made a clear proposal on this, but he did mention returning the estate tax to 2009 levels, which implies a top tax rate of 45% and an estate tax exemption amount of $3.5 million (indexed annually for inflation).

Many of the planning techniques that we talked about last year and that you mentioned earlier still make sense. For example, you might want to use your remaining estate and gift tax exemption this year through generation-skipping transfer trusts or dynasty trusts for children and more remote descendants, or through spousal access trusts for married individuals.

One idea we’ve heard tossed around that attempts to solve for some of the existing uncertainty relates to the use of a spousal access trust that can essentially be turned into a marital trust. This would allow for the use of the marital deduction, rather than the exemption amount, in the event that the exemption amount goes down and the change is retroactive. And if a disclaimer provision is included, it may buy a little time (nine months to be exact), to see how things go.

The other thing I wanted to mention is the basis rules. Current law provides for a step-up in basis for inherited assets, and Biden’s proposal is to eliminate stepped-up basis at death. Here, the planning suggestion is to be vigilant about basis management and not let plans become stale. Revisit what you have in place, and make sure that it still makes sense.

AH: That’s important for people who set up trusts in 2012 and 2020. When we talk about basis management, most of those trust agreements allow the grantor to swap assets into and out of the trust. If the current law allowing a step-up in basis at death doesn’t change, you should be proactively and consistently keeping the lower basis assets in your taxable estate and putting higher basis assets into those trusts that are not going to get that basis step-up when you pass away. And if those rules do change, this planning may become less important.

AH: What are some changes that specifically impact business owners? What can business owners do now?

SK: First, the Tax Cuts and Jobs Act reduced the corporate tax rate from 35% to 21; Biden’s proposal is to increase it to 28%. Second, under current law, for businesses structured as pass-through entities, rather than as corporations, income passes through to the owner, who is then taxed at his or her individual rate, with a 20% deduction under section 199A for domestic profits. That deduction is currently set to expire at the end of 2025. Biden’s proposal is to phase out the section 199A deduction for filers with income over $400,000. For bonus depreciation, there’s currently a 100% deduction available, and Biden would likely be in favor of eliminating that deduction.

With respect to pending transactions, many business owners we work with tried to close their deals by the end of 2020 due to the uncertainty in tax policy in 2021. However, if you’re in the middle of a deal or if you’ve been considering selling your business in the next couple of years, you may want to move forward with the transaction given that taxes are likely to increase in the near term. The long-term capital gains rate is particularly relevant in this context. If the current rate of 20% goes up to 39.6% under Biden’s administration (for those with taxable income over $1 million), that would obviously have a significant impact on the sale of a business. Having said that, it’s important to note that we would never suggest selling your business just because of taxes – it’s a very personal choice with many considerations, only one of which is tax consequences.

Business owners may also want to accelerate ordinary income to 2021, consider paying dividends this year rather than deferring them to the future and take advantage of the bonus depreciation deduction while it’s still available.

AH: Shifting topics a bit to our philanthropic families and endowment and foundation clients, since we’re in the income tax realm: Are there things that are changing in terms of charitable giving this year, and are there actions that they should take?

SK: The main thing to note here is that the Coronavirus Aid, Relief, and Economic Security (CARES) Act deductions have been extended through 2021. Under the CARES Act, taxpayers can deduct up to 100% of adjusted gross income (AGI) for gifts to public charities, up from the 60% deduction allowable prior to the CARES Act. A similar point should be made about corporate giving. The limitations for cash contributions remain increased in 2021 for corporate donors, who may deduct up to 25% of taxable income, up from 10% prior to the CARES Act. This is a great time for charitable giving for many reasons, including taxes.

AH: There are a couple of rumors floating around about changes to the estate and gift tax world, with areas of focus including family limited partnerships (FLPs), intra-family loans and grantor retained annuity trusts (GRATs). What should our clients be considering in the next year or so as it relates to these three items?

SK: We recommend cleaning up FLPs, especially those holding only marketable securities. We’re not sure if there will be anything here from a tax reform standpoint, but there’s no downside to getting these right. They’re a little bit on the risky side, so we work with our clients to respect the entities as separate structures – for example, they should have their own, separate bank accounts from which entity-level bills are paid. If percentages of the entity have been transferred to trusts, then their ownership schedules should reflect the changes, and gift tax returns should be filed reporting any gifts or relevant sales.

With intra-family loans, we would recommend that if it’s really a gift, turn it into a gift by forgiving the loan. And if it’s really a loan, make sure that it is properly documented and that the borrower is paying interest on it, or refinance it and make a payment of principal or something that’s commercially reasonable to be very clear (with evidence) that it is a loan in the truest sense of the word.

Finally, with GRATs, if you’ve considered doing one in the past, you may want to revisit the idea if it still makes sense for you. These are always on the chopping block, but they’re typically not at the top of the list, so if you’re interested, it’s a great time to pursue one.

The bottom line here is that there probably won’t be too much happening, especially on the transfer tax front, in the near term – and if and when something does happen, it probably won’t be a retroactive change. While it’s never possible to have 100% certainty with this sort of thing, if you’ve already started down the path with estate planning that is a good idea anyway, you should probably continue down that path.

AH: Thank you, Stacia, for your insights on what we can do today to take advantage of existing rules, even while a potential new tax code is still taking shape.


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InvestorView Q4 2020

In this issue of InvestorView, we cover several topics related to the election, including potential implications, family dynamics during this time and considerations for charities, and provide an update on the market and our portfolio positioning.

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