Proactive measures for the rich to be thought of prematurely of doable tax law modifications

A wealthy man is working on his sports car. Getty Images

Recently proposed tax law changes, when they come into effect, will significantly transform the tax and estate planning landscape for high net worth individuals. While the final form of these proposals is by no means certain, wealthy individuals should take steps this year to mitigate the risk of potentially unfavorable tax law changes.

Background and Governing Law

Under current law, the federal gift and inheritance tax exemption is higher than ever before. Individuals can currently donate up to $ 11.7 million in wealth during their lifetime or in the event of death without incurring gift or inheritance taxes. Couples can give up to $ 23.4 million tax free.

The current high tax exemption is expected to return to the pre-2018 level from 2026. When that happens, the exemption will drop to about $ 6 million. Gifts in excess of this amount are subject to gift or inheritance tax, which is calculated at approximately 40% of the value of the assets transferred.

Currently, neither lifetime gifts nor bequests trigger income tax for recipients. Lifetime gift recipients take a "carryover" basis on gifted assets in order to receive any unrealized gains. Assets that perish after death are given a base “step-up” to fair market value, effectively wiping out any unrealized gains in assets that are at the time of death.

Proposed tax law changes

In late May, the US Treasury Department published a General Notes on the Government Proposed Revenue for Fiscal Year 2022 (also known as the "Green Paper"), which outlined the Government Proposed Revenue. The Green Paper contains several proposals that could have a dramatic impact on the tax debts of wealthy taxpayers.

The government is proposing to raise the top tax rate for individuals (and presumably trusts) from 37% to 39.6% (the pre-2018 rate). In 2022, this higher tax rate would apply to taxable income above $ 509,300 for joint applicants and $ 452,700 for single parents. After 2022, the brackets will reset based on inflation. This change is scheduled to begin in 2022.

The story goes on

The government has also proposed taxing long-term capital gains and qualified dividends for taxpayers with adjusted gross income over $ 1 million at normal income rates. This change would result in a federal tax rate of up to 43.4% (suggested 39.6% + 3.8% net investment income tax). The higher tax rate on long-term capital gains and qualifying dividends would only apply to the extent that the taxpayer's AGI exceeds $ 1 million. This change is expected to come into effect in April 2021 (i.e. retrospectively from the future effective date).

Finally, the administration plans to treat gifts and remittances in the event of death as income-realization events. Gifts and bequests would be treated essentially as if the donor (1) sold the property in order to realize a gain or loss; (2) bought back the property; and (3) identical substitute gifted assets, meaning that any previously unrealized gain would be recognized by donors and income taxes paid on the "phantom" profit. Most trust transfers of valued property and distributions (including most grantor trusts) would also trigger recognition.

As currently proposed, the transfer of valued assets to charity would not generate a taxable capital gain. In addition, any person could exclude US $ 1 million of Phantom profits from recognition (a lifetime exclusion from gifts or transfers in the event of death). Transfers to a surviving spouse in the event of death would not trigger immediate recognition of the gain, but the surviving spouse would incorporate a carryover base into the transferred property – i.e. tax liability would be triggered upon the death of the surviving spouse or earlier in the case of a lifelong gift. This change is scheduled to begin in 2022.

The Green Paper did not propose any changes to the current gift and inheritance tax laws. Under the Income Realization Proposal, the giver may be subject to both income and transfer taxes on a single transfer. In addition, long-term capital gains generated through gifts can be taxed at higher ordinary income tax rates.

Planning considerations for 2021 and beyond

It is important to remember that the Green Paper proposals are just that – proposals. The legislative process will undoubtedly change significantly the details of any final bill. The forces of compromise and political expediency can reduce the harshness of these proposals (including whether any of the proposals have retrospective effect). However, wealthy taxpayers may want to take a few steps to proactively protect themselves:

  • With higher income tax rates looming, high-income individuals (and potential trusts) may want to draw some income into 2021. For example, individuals considering converting a traditional IRA to a Roth IRA should take this step in advance by the end of 2021, when the highest income tax bracket may be lower.

  • Keeping the AGI below $ 1 million for the coming year can also serve to avoid higher interest rates on long-term capital gains and qualified dividends. Accordingly, postponing any deductions (e.g., charitable donations) to 2022 or later may make the deduction more valuable due to the proposed changes.

  • The use of the currently lower income tax rates on long-term capital gains by triggering profit realization in 2021 may make sense for some, especially if a sale makes sense for non-tax reasons (e.g. diversification). There are no rules prohibiting wash-gain transactions and valued securities can be repurchased instantly with no penalty. With uncertainty about how final tax laws will shape, hastening big profits can be risky; wait and see approach may be best.

When it comes to estate planning, I can think of a few other courses of action:

  • While concerns about lower short-term gift and inheritance tax exemptions have been allayed, from 2022 large gifts can trigger significant income tax on phantom profits (which may be taxed at a higher rate). If future transfers trigger income recognition in the event of death, a gift in 2021 can make sense – both to avoid recognition of future gifts and to take advantage of the historically large exemption from gift tax. For individuals or couples whose financial independence (and personal risk tolerance) allows them to claim their remaining gift tax exemption, gifts for 2021 will continue to be beneficial.

  • Transferring higher taxable assets to the taxable estate can reduce the impact of the proposed profit recognition regime on transfers in the event of death. Traditional planning often involves the reallocation of low tax base assets to an individual's personal name or revocable trusteeship. This is to ensure that assets with a low assessment base are included in the taxable assets of the person in order to achieve an increase in the assessment base in the event of death. According to the proposed changes, owning low-base assets in the event of death can result in significant income taxes; Death from owning higher-base assets can mitigate this risk.

The bottom line

Individuals considering changing their estate plans should seek extensive advice from an experienced tax professional. Depending on the individual circumstances, some steps can backfire if the final laws differ from the proposed changes. Hopefully the details of future tax law changes will become clearer in the coming weeks, which will make the planning results more secure.

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