It’s déjà vu all over again — and another bout of uncertainty and frustration for financial advisors — with the White House’s proposal to increase taxes on the wealthy.
President Joe Biden’s federal budget proposal released March 28 both resurrects prior efforts to raise taxes on the richest Americans and introduces new curbs. Among other things, it revives earlier proposals to end tax-free wealth transfers to heirs and to collect tax on investors’ paper profits. Currently, capital gains are taxed only when a stock or other asset is “realized,” or sold, and at rates below those for labor income.
The proposal also calls for ending a loophole known as step-up in basis, in which people who inherit assets don’t owe tax on the gains that materialized from the time the original owner acquired them. One thing left out: a prior proposal to impose severe curbs on tax-free Roth retirement accounts. It’s possible that some of the other proposals in the document would do at least part of that.
The $2.5 trillion in proposed tax hikes is on top of $1.5 trillion in increases contained in a stalled version of the Build Back Better bill. The budget faces an uphill battle in Congress — and exasperation from advisors.
“They couldn’t pass anything last year — how are they going to get it through this year with so much more on their plate?” like inflation and Russia-Ukraine, asked Martin Shenkman, an estate planning lawyer based in Fort Lee, New Jersey. “We’re all, ‘oh golly, it’s all proposed all over again.’ But clients don’t want to hear the Chicken Little routine anymore. Clients have planning fatigue. It’s like (the movie series) ‘Friday the 13th’ — how many sequels were there?”
Still, Shenkman said that planners have to let clients know what’s happening. Here’s what affluent investors and financial advisors need to know:
A 20% tax on centi-millionaires and billionaires on all of their “income,” including unrealized gains, or paper profits:
The “Billionaire Minimum Income Tax” would hit the richest 20,000 American households, according to The Wall Street Journal, and raise $361 billion over 10 years, according to the Treasury Department’s latest “Green Book,” which lays out the administration’s proposed spending and tax increases.
The tax is a misnomer as it would hit people earning at least $100 million who don’t already pay at least 20% in taxes on their income and unrealized gains. Top earners who pay less would owe the difference up to 20%. Boston Consulting Group defines those earning at least $100 million as ultra high net worth and said their assets rose nearly 16 percent in 2020 to $5.3 trillion compared to the prior year.
The idea of taxing profits that exist on paper, not as cash in a bank account, first appeared last year in various proposals from Biden and lawmakers in both chambers. The calls failed. The Green Book said that “reformed taxation of capital income would even the tax treatment of labor and capital income and eliminate a loophole that lets some capital gains income escape income taxation forever.”
Under current “step-up in basis” rules, someone who inherits an asset that swelled in value in prior years doesn’t have to pay income tax on the increase. That’s unfair, according to Treasury. Why? Because less-wealthy people who have to spend their savings during retirement pay income tax on their realized capital gains. “This dynamic increases the inequity of the tax treatment of capital gains,” the Green Book said.
A new top ordinary income tax rate of 39.6%, up from 37%:
- The top rate would start in 2023 and apply to married couples earning more than $450,000 and single filers making more than $400,000.
- For 2022, the current top 37% rate is paid by married couples making more than $647,850 and individuals making more than $539,900.
- The increase would raise nearly $187 billion over a decade.
Capital gains:
- Long-term capital gains and qualified dividends for people earning more than $1 million would be taxed at the proposed top ordinary rate of 39.3%, plus 3.8% for the Affordable Care Act. Currently, capital gains are taxed at 23.8%, including the Obamacare levy.
- Unrealized gains would be taxed when an owner dies.
Estate and gift taxes and trusts:
Last fall, grantor trusts, the engine of wealth transfers to heirs, were on the chopping block. That’s in part because an early version of the climate and social spending bill known as Build Back Better treated future sales between trusts and their owners — a common planning technique — as a taxable sale.
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Now trusts are facing another hatchet. Biden’s budget proposes to “modify income, estate and gift tax rules for certain grantor trusts.” The changes would raise nearly $42 billion. Under the budget:
- Donors would recognize a capital gain when transferring an asset to an heir. The gain would consist of the amount of appreciation in the asset since it was originally acquired.
- A donor could exclude, or not owe tax on, $5 million of unrealized capital gains on property that is transferred by gift or owned at death.
- The $5 million exclusion is in addition to the lifetime exclusion, now just over $12 million (twice that for couples).
- The rule would go into effect in 2023.
- The rule would also affect “certain property” owned by trusts, partnerships and other non-corporate entities on January 1, 2023.
- Portions of the $5 million exclusion that aren’t used during a donor’s lifetime would carry over to a surviving spouse.
- Taxpayers could choose not to recognize unrealized appreciation of a family-owned and -operated business until the business is sold or passes out of the family’s hands. They’d have 15 years to pay tax on appreciated assets transferred at death. With a deferral, taxpayers would have to put up “security” to the IRS if asked.
- If a trust, partnership or other non-corporate entity hasn’t recognized gain on its assets since 1939, it would be forced to do so come 2030.
- The rules for grantor retained annuity trusts, or GRATs, get tighter. They’d be required to have a minimum value for gift tax purposes of at least 25 percent of the value of the assets transferred to the GRAT or $500,000, whichever is bigger.
- A trust would be banned from swapping assets without recognizing gain or loss. The trusts would last a minimum 10 years and a maximum of 10 years plus the owner’s life expectancy.
Private equity and hedge funds:
So-called “carried interest” profits would be taxed at ordinary rates, not capital gains rates.
Steve Wittenberg, the director of legacy planning at SEI Private Wealth Management in Oaks, Pennsylvania, said in an email that there’s “fatigue from taxpayers coming out of the frequent rollercoaster of potential proposals to change tax laws.” The proposals, he added, “more often than not do not come to fruition.”