Daniel F. Rahill, CPA, JD, LL.M., CGMA, managing director at Wintrust Wealth Management, shares what investors and family offices should keep in mind and plan for in 2021, as President Biden and the Democratic majorities in the House and Senate plan a major individual and estate tax overhaul.

On April 28, 2021, President Biden released his American Families Plan, proposing tax hikes on people earning more than $400,000 a year, nearly doubling capital gains rates, and eliminating the “tax-free” basis step-up at death by subjecting unrealized gains to the new 43.4% capital gains tax. On May 28, 2021, the Department of the Treasury issued its “Green Book” which outlines the Biden administration’s proposals, including information on effective dates not previously provided.

The American Families Plan

Higher individual income tax rates
The American Families Plan proposes to raise the top individual tax rate from 37% to 39.6% in 2022. The Green Book’s new top rate applies to taxable income over $509,300 for married individuals filing a joint tax return, which is the top 2017 tax bracket adjusted for inflation. This is an increase from President Biden’s original $400,000 top tax rate threshold proposal. Those affected will want to deploy basic tax bracket management strategies for times of rising tax rates, such as accelerating income into 2021, making Roth IRA conversions, exercising stock options, and taking bonuses in 2021 if possible.

Higher capital gains and qualified dividend rates
Under the American Families Plan, individuals earning over $1 million would be subject to ordinary income tax rates as high as 39.6% on their long-term capital gains and qualified dividends. In contrast to other individual tax provisions that would be generally effective for tax years beginning after December 31, 2021, the president’s proposal to increase capital gains tax rates is proposed to be retroactively effective “for gains required to be recognized after the date of announcement.” Biden administration officials have indicated that “date of announcement” is meant to be April 28, 2021, the date President Biden announced his American Families Plan. Investors with incomes over $1 million should still consider selling appreciated assets in 2021, should the elimination of the 20% preferential rate for long-term capital gains and qualified dividends be changed to years beginning after December 31, 2021, in congressional negotiations. This effective date should be monitored closely as these negotiations proceed this summer.

Other planning techniques and opportunities include funding future investments using loans collateralized with low-basis stock instead of selling the stock and triggering the tax, investment in opportunity zone funds, gifting of appreciated assets (also to utilize the current estate and gift tax exemption), and charitable contributions of appreciated assets to qualified charities, including donor-advised funds and private foundations.

Estate and gift tax changes
The proposed act would eliminate the “tax-free” basis step-up at death by requiring taxation of all unrealized gains in excess of the $1 million (or $2.5 million per couple when combined with existing real estate exemptions) as of the date of death. As a consequence, assets with large unrealized gains would no longer be allowed to escape taxation when passed down to future generations. The plan refers to exceptions if the property either is donated to charity or is related to a family-owned business/farm that the heirs will continue to run. The proposal would be effective for gains on property transferred by gift and on property owned at death by decedents dying after December 31, 2021.

Elimination of most tax-free like-kind exchanges
Currently, gains on transfers of real estate can be tax-free; a taxpayer can defer the gain on a property by exchanging it for a different one. The Biden plan would eliminate this tax-free technique where the gain exceeds $500,000 and would be effective for tax years beginning after December 31, 2021, regardless of the date upon which the exchange may have begun.

Expansion of the 3.8% net investment income tax
The Green Book proposal would expand the scope of self-employment taxes and the net investment income tax to require that, for ‘high-income taxpayers’ ($400,000 of income, not indexed for inflation), all income derived from a pass-through trade or business be subjected to one or the other regime. The Green Book indicates the proposal would be effective for tax years beginning after December 31, 2021. For investors, the proposal raises new questions regarding choice of entity, e.g., C corporation vs. pass-through form, for income tax purposes.

Carried Interest
Finally, Biden’s plan calls for the elimination of the favorable capital gains tax treatment of carried interest. Although the benefit of capital gains rates on carried interest would be eliminated by the general increase in capital gains rates to 39.6% for those making more than $1 million, the American Families Plan fact sheet describes an intent to make structural changes to the treatment of carried interest, apparently so that any future reduction in capital gains rates would not benefit allocations on carried interest. The effect of this proposal would be limited to taxpayers earning greater than $400,000 in a year. Taxpayers earning under this threshold would continue to be subject to the existing three-year rule for long-term capital gains attributable to carried interests. The proposal would be effective for tax years beginning after December 31, 2021.

Additional proposals being considered

Perhaps the biggest surprises to come out of President Biden’s American Families Plan were the many campaign proposals there that were not included in the plan. Therefore, the door remains open to future legislative tax-increase proposals. The following proposals should also be considered as these could be proposed in the future.

Limits on itemized deductions
The Biden campaign previously proposed limiting the value of itemized deductions for taxpayers with more than $400,000 of income to a 28% tax bracket benefit. Itemized deductions would be further limited at that income level by restoring the pre-2018 Pease Limitation, which would reduce itemized deductions by 3% of AGI up to 80% of itemized deductions. The elimination of the $10,000 state and local tax (SALT) deduction cap was also not included in the American Families Plan. Itemizers should plan to defer SALT payments until 2022 should the SALT cap be eliminated at a later date.

Retirement plan contributions
The Biden campaign also proposed to convert retirement plan contributions from a current deduction into a refundable 26% tax credit for each dollar contributed. The result is that instead of getting a tax benefit based on your top income tax bracket, e.g., 39.6% top tax bracket benefit for a retirement plan contribution, a taxpayer would receive a flat 26% benefit from the credit. Roth tax treatment would be unaffected and therefore, higher income taxpayers would more likely shift to more Roth-style plans after this law change.

Increased payroll taxes
A Biden campaign payroll tax proposal would subject wage and self-employment income in excess of $400,000 to the Social Security payroll tax. Currently, the 6.2% tax is on the first $142,800 of wage income, so wages and earnings between $142,800 and $400,000 would not be taxed, creating a donut-hole structure.

For self-employed individuals who pay both the employee and the employer halves, the tax is 12.4%. A self-employed professional making $1 million a year would see their self-employment (SE) tax increase by $74,400, mitigated slightly by the fact that the 50% employer-equivalent portion would be deductible in calculating AGI.

Estate tax exemption and rates
The Biden proposal targets estate taxes by proposing to eliminate the tax-free basis step-up at death, as noted above. Broader changes to the estate tax exemption and rates, proposed during his campaign, were not included in his American Families Plan. These campaign proposals could easily be revisited in the future as part of this plan or as part of another bill.

The 2021 estate tax exemption threshold is $11.7 million per individual (indexed for inflation) with a top tax rate of 40%. After 2025, this amount will revert to the pre-2018 exemption, which is an indexed amount that would equate to approximately $5.8 million. The Biden campaign plan would accelerate the reduction of the exemption to $3.5 million with a top tax rate of 45%.

Further, on March 25, 2021, Senator Bernie Sanders, I-V.T., released his “For the 99.5 Percent Act,” which proposes to reduce the estate tax exemption amount to $3.5 million, not indexed for inflation. For a married couple, the non-taxable exemption would be reduced from today’s $23.4 million to $7 million. The plan would also reduce the current gift tax exemption to only $1 million from $11.7 million, and would impose a new annual limit of $30,000 on non-taxable gifts in trust or gifts of entity interests in any one year.

The Sanders' proposal would also increase estate tax rates as follows:

• 45% of the value of an estate $3.5 million to $10 million
• 50% for $10 million to $50 million
• 55% for $50 million to $1 billion
• 65% over $1 billion

By comparison, the original Biden campaign proposal would tax estates valued at $3.5 million or more at a flat 45% rate, up from 40% currently. Again, neither of these proposed changes is in the American Families Plan but they could reappear at a later date. The Sanders plan also proposes that certain estate planning trust structures used by family offices, such as Grantor Retained Annuity Trusts (GRATs), Spousal Lifetime Access Trusts (SLATs), or Dynasty trusts could be modified or eliminated, as would minority valuation discounts for non-business transfers. These changes could be effective as early as the date of the enactment of the bill into law.

On March 31, 2021, Senator Chris Van Hollen, D-M.D., and others introduced the Sensible Taxation and Equity Promotion (STEP) Act, which would also eliminate the “basis step-up” at death. The STEP Act would cause gain recognition on assets transferred by gift, by a distribution from a trust, and upon death, subject to limited exceptions. This proposal would actually be retroactive to January 1, 2021, although retroactivity does not appear likely.

Key takeaways

The American Families Act, coupled with the Sanders’ “For the 99.5 Percent,” the STEP Act, and the numerous other campaign tax-increase proposals, all contain provisions which would significantly increase income, estate, and gift taxes for family offices and higher-income taxpayers. These proposals need to be planned for now in anticipation of a likely January 1, 2022, effective date (although some provisions could be effective even sooner, such as when an act is passed into law). Therefore:

• Don’t wait until year-end to complete annual exclusion gifting. Consider maximizing gift amounts before the law changes or the year comes to an end.
• Consider fully using most (if not all) of your current lifetime estate, gift, and generation-skipping tax exemptions.
• It appears revisions to GRAT structures will apply only to GRATs executed after the date of any enacted legislation, so the time to put a grantor trust structure in place is now.
• If you plan to sell certain assets or business interests, consider closing before year-end. If long-term capital gains rates increase in 2022, financial realization of capital gains now at the lower rates would be effective planning. Similarly, should the loss of stepped-up basis at death proposal be enacted, planned sales of appreciated assets should be completed before year-end.
• As always, gifting to family and charitable interests are two possible mechanisms to reduce estate tax exposure.

This is the time to reach out to your investment or family office banking advisor to discuss these proposed changes and develop tax saving strategies for you and your family. If you have any questions, we would be happy to delve into more detail as it pertains to your specific situation.

Experts with Wintrust Family Office Banking can help you navigate these changes and find solutions that fit your unique needs. Visit our website to connect with a banker.