“…in this world nothing can be said to be certain, except death and taxes.”
The quote above, attributed to Ben Franklin, is a well-known excerpt from a letter to French scientist Jean-Baptiste Leroy in 1789 where he discussed the new Constitution that had recently been adopted in the United States.
President Joe Biden has proposed plans in his first few months in office that may pair those two events even more so than Franklin may have imagined. Perhaps the most talked about change, at least with my clients, has been the American Families Plan. The plan seeks to pay for free college, family benefits such as pre-school, extended tax cuts for lower income families, and other programs costing $1.8 trillion by raising taxes.
The top tax bracket would increase to 39.6% (from 37%) on incomes greater than $540,000. That would return those rates to the level they were at prior to the 2017 tax cuts under the Trump administration. That modest change, however, is not what has drawn the attention of many high-net-worth individuals and business owners. The proposal to nearly double capital gains rates from 23.8% (20% Long-Term Capital Gain Tax + 3.8% Net Investment Income Tax) to 43.4%, on the other hand, has raised some eyebrows. Even more concerning, the administration wants to force heirs to pay capital gains tax when the owner of the asset dies.
Oh, and the taxes will be retroactive to April of this year. Which all leads to the question, what can be done now from a planning perspective?
If you already took your $1 million plus in profits from Gamestop and Bitcoin last month, there may not be a lot you can do if these proposals make it through Congress. But for the rest of us, there are many planning strategies available to potentially mitigate some of the proposed tax increases.
First, the capital gains increase that has been proposed will only impact those with incomes of over $1 million. That, on the surface, seems to eliminate concerns for even many high-net-worth individuals. However, it is the forced realization of capital gains at death that could likely wind up costing the unsuspecting.
Currently, if you own an asset like a stock or a business, you may owe capital gains tax if you sell for a profit. The price you paid for the asset is known as your Cost Basis. However, when you die, your heirs receive those assets with what is known as a “Stepped Up Basis”, which essentially changes the Cost Basis to the value on the day the owner dies.
So, if you bought $10,000 of Amazon back in 2001 at $12/share, the 833 shares you bought would now be worth $2,700,000. If you died today, the $2,690,000 of profit would pass to heirs free of capital gains tax and their new Stepped-Up Basis would be $2,700,000. Also, if the deceased is worth less than $11,700,000, there would also be no estate tax owed. Under the proposed new rules, death is treated as a “sale” and the capital gains tax will be $1,167,460 (23.8% of the gain) since the “income” from the sale will be included in the gross income used to determine the tax rate.
And that does not include the additional impact of another proposal that will lower the Estate Tax exemption from its current $11.7 million per person level down to $3.5 million per person. As seen in Exhibit 1, potential taxes may be significant for even modest “High-Net-Worth” estates. As can be seen in the simple examples, the higher tax rate plus forced realization of gains at death can be quite expensive, even if the lower estate tax threshold isn’t reached.
Exhibit 1. Examples of Current vs Proposed Capital Gains and Estate Taxes
Fortunately, there are still planning strategies to potentially mitigate some of the worst case scenarios. Even if you currently do not think of yourself as “wealthy”, having a couple of million in assets today (including life insurance benefits) could easily result in your estate exceeding $3.5 million in a few years. In short, even folks that may think of themselves as just “affluent” should review their estate plans.
Estate planning can incorporate many strategies to minimize income taxes, capital gains taxes, gift taxes, property taxes, death taxes, and generation-skipping transfer taxes.
Some strategies that could make sense include:
Irrevocable Trust which transfers property into the names of your heir(s) immediately, while retaining rights to an income stream for a period of years or for life.
IRA Inheritance Trust.
Irrevocable Life Insurance Trust.
Charitable Trust or Pooled Income Fund that pays you or your loved ones benefits while living.
Spousal Lifetime Access Trust to “lock-in” current estate tax exemptions.
Sale to an Intentionally Defective Grantor Trust.
Private Annuity.
Exchange Funds for deferring capital gains tax on a concentrated position.
Completing key real estate transactions, such as 1031 exchanges (which are also potentially on the chopping block), before laws are changed.
Locating assets in the most efficient places (i.e. Roth IRAs).
Annual and lifetime gifts.
Some of these techniques will require legal assistance but all of them are part and parcel to a comprehensive financial plan. Many clients I talk to have not been concerned about estate tax (or capital gains tax) planning with current laws allowing couples to pass up to $23+ million to heirs free of estate and capital gains tax. But with the new Biden proposals, now is the time to revisit or create your plan.
Get in touch if you would like to discuss yours.