Here are the changes we expect to happen—and what you might do now to mitigate their impact.
Tax rate increases are likely coming for the wealthy—and will probably go into effect starting next year. The question is: What, if anything, might you do now to lessen the impact of those higher taxes later?
In the American Families Plan and American Jobs Plan unveiled this spring, President Joseph R. Biden proposed the government spend nearly $2 trillion on infrastructure and another $1.8 trillion on social programs. To pay for any legislative package that contains some of these outlays, Democrats, who narrowly control both houses of Congress, are expected to raise taxes.
A number of changes to tax law are on the table. There are five that we think have a good chance to become law and, if enacted, may affect your finances. These changes would: 1) increase the long-term capital gains (LTCG) tax rate on high-income earners; 2) eliminate the “step-up in basis” rule; 3) reduce the estate and gift tax exclusion amount; 4) raise the top ordinary income tax rate; and 5) increase the corporate income tax rate.
Whatever your feelings about these potential tax changes, there are actions you might want to consider taking now to mitigate their impact on your finances. We can help you decide whether these moves may be right for you in light of your long-range financial goals.
1. Increase the long-term capital gains tax rate
Democrats have proposed raising the long-term capital gains tax rate from the current 20% to 39.6% for individuals who earn more than $1 million a year. We do not think the LTCG will go as high as 39.6%, even for the highest earners. However, we do think it is highly likely that the rate will increase, possibly to 25% or even 28%.
What you might do now
- Sell stocks—It would obviously make sense to sell highly appreciated public stocks before the rate changes. However, decisions to sell stocks never should be made on tax rates alone, let alone on what future tax rates might be.
- Smooth income—Taxpayers earning around the amount that would trigger the higher rate could “smooth” their income over a period of years, instead of taking a lump sum in one year. For instance, a business owner selling his business might—instead of taking $1.5 million in 2022 and triggering a gain of that amount subject to the higher rate—take two payments of $750,000 (one in 2022 and one in 2023).
- Adjust other investments—Another possibility might be to invest in assets that do not generate “adjusted gross income” (AGI), which is the expected definition of “income” under this law. That would mean, for example, investing in municipal, rather than corporate, bonds. Or you might decide to acquire variable life insurance or annuity products, as their internal growth is not currently subject to income tax.
2. Eliminate the “step-up in basis”
The American Families Plan seeks to effectively repeal the rule that allows, on the death of the owner of assets, the “basis” (cost) of those capital assets to be adjusted to their fair market values, generally on the day the owner dies.
Under the Plan, only $1 million could be stepped up when someone dies. The Biden administration also has made vague references to excluding from this repeal up to $500,000 of gain for a married couple’s primary residence, as well as the gain from small family businesses and farms that heirs continue to operate.
This is potentially a very significant change, and here’s why: Say a couple bought a stock for $200,000 when they were newlyweds. Sixty years later, when the second of the two spouses dies, that stock passes to the couple’s children. By then, the stock’s fair market value is $10 million. Their children inherit this asset worth $10 million but—and here’s the important part—under current tax law, no one has to pay capital gains taxes on the $9.8 million of appreciation.1
It is not clear, under Biden’s proposed change, whether the children or the decedent’s estate would immediately owe capital gains tax on $9.8 (or perhaps only $8.8) million, or simply that their basis in the asset would be kept at $200,000. What is clear is that the under the administration’s proposal, most if not all of the unrealized gain would not simply disappear for tax purposes, as it has for 100 years.2
What you might do now
- Transfer assets now—If you can afford to do so without impinging on your lifestyle, you might transfer assets today to those people who’d receive them upon your death.3 If the step-up rule were repealed, the reason that people often give for not transferring assets while they are alive—so the family would benefit from the step-up when they die—would vanish. And if the step-up rule is not repealed, a grantor-type trust would allow low-basis assets to be reacquired for basis step-up purposes.
3. Reduce the estate and gift tax exclusion amount
Many observers were surprised that the American Families Plan made no reference to reducing the estate and gift tax lifetime exclusion amount. (It also did not propose increasing the tax rate from the current 40%.) However, the Biden campaign did advocate for reducing those exclusion amounts, and Democrats in Congress generally support such a change.
We think it is possible that the estate and gift tax exclusion amount will be dropped from the current $11.7 million down to $5 million. If so, this amount likely would be adjusted for inflation. That would mean the amount each individual might transfer free of estate and gift taxes during their lifetime would be about $6 million in 2022.
What you might do now
- Transfer assets now—It is always true that more family wealth is preserved the sooner a senior generation transfers assets to future generations (either directly or in trust for their benefit).4 If the exclusion amount is significantly reduced, that truism—sooner means more wealth stays in the family—would be even more true.
4. Raise the top ordinary income tax rate
The American Families Plan proposes to increase the top ordinary income tax rate from its current 37% to 39.6%.
Based on the intelligence we have at the time of this writing, we expect that any tax legislation that passes this year strictly along a party-line vote will include this provision, as it is almost uniformly supported by the Democrats.
What you might do now
- Accelerate income—If the option is available to you, realize ordinary income late in 2021 (for instance, by exercising non-qualified stock options), rather than early in 2022.
- Convert to Roth IRAs—You also may want to look into converting your existing traditional IRAs (distributions from which in future years would be taxable at ordinary rates) to Roth IRAs (distributions from which would not be). The conversion itself would be taxable, but at a top rate of 37%, not a possible 39.6%.
- Defer income—If the option is available to you, consider deferring bonuses and other forms of ordinary income into a future time when you expect your income (and tax bracket) will be lower.
5. Increase the corporate income tax rate
The Biden Administration has proposed increasing the corporate income tax rate from the current 21% to 28%. As with the long-term capital gain rate, we do not think the rate will ultimately be as high as is proposed. Instead, we do think there is a very good likelihood it would go up to 25%.
What you might do now
- Owners of small businesses—You may want to convert your existing separate tax-paying corporations to another form of organization, such as a limited liability company (LLC). Corporations under the new regime could be subject first to a corporate income tax rate of, say, 25%, and then if distributed as a qualified dividend at a rate of, say, 28% plus the Medicare surtax of 3.8%, leaving a net of 50.2%.
In contrast, income earned through an LLC would be subject to just one level of tax, perhaps at the top ordinary income tax rate, leaving a net of 60.4% for a business principal(if the top rate were to go up to 39.6%), less the Medicare surtax, leaving a net of 56.6%.
- Investors—You might want to explore securities, such as bonds, that would be relatively more attractive than stocks paying dividends subject to less preferential tax rates and received from companies subject to higher corporate taxes. Your J.P. Morgan investment specialist can review your portfolio to identify how you might want to reallocate to increase the tax-effectiveness of your holdings.
You have some time—but not much
We believe that lawmakers are likely to pass some tax legislation by the end of September 2021 and that most, if not all, of the new provisions would go into effect on January 1, 2022. Try to get ahead of that curve. We’re here to help you anticipate the potential changes—and prepare to execute on your new plan as soon as there’s greater clarity about what, precisely, the new tax laws will be.
1 Of course, if the stock were valued at $10 million, then estate taxes might be owed on the couple’s estate, depending on the estate’s overall size.
2 It is very hard to handicap the odds that the step-up will get repealed. The provision has been in the law for a century (with one year off, in 2010). Repeal was tried in the late 1970s, and at the time was found to be administratively too difficult to implement. Lawrence Zelenak, Taxing Gains at Death, 46 Vanderbilt Law Review 361, 388, 390 (1993).
3 Usually by passing directly to children or in trusts, perhaps “grantor” type, for their benefit.
4 That is because estate tax would not have to be paid on appreciated assets and because of the unusual manner in which gift taxes are calculated, the effective gift tax rate is only 28.6% (not 40%, the estate tax rate).