A Night to Remember?
Did you listen to the President’s speech last Wednesday? He addressed a joint session of Congress to pitch the Administration’s $1.8 trillion American Families Plan. Due to COVID-related restrictions, there were only about one hundred elected officials present in the House Chamber;[i] other invited guests brought the total in attendance to approximately two hundred.[ii]
The sparsely occupied room was to be contrasted with the targeted audience: the almost 27 million U.S. viewers who tuned into Mr. Biden’s speech, and whom he hoped to enlist in his effort to sway a closely divided Congress.[iii]
In advance of the President’s address to Congress, the White House released a summary of proposed changes to the Code which, together with Mr. Biden’s previously announced plans to collect more income tax from larger corporations,[iv] are intended to help fund the American Families Plan.[v]
According to the summary, Mr. Biden’s goals for these amendments are to (i) “eliminate long-standing loopholes” (singling out the current treatment of capital gains and dividends),[vi] (ii) ensure that the wealthiest Americans “play by the same rules as everyone else,” and (iii) compel the wealthy to pay their “fair share” of taxes.
Among the measures included in the Administration’s summary were the following:[vii]
- Increase the top federal tax rate on ordinary income for the wealthiest Americans from 37 percent to 39.6 percent.[viii]
- Increase the tax rate on long-term capital gains[ix] arising from the actual or deemed[x] disposition of property by wealthy Americans from 23.8 percent to 43.4% in the case of households making over $1 million during the taxable year.[xi]
- Increase the tax rate for qualified dividends[xii] from 23.8 percent to
43.4 percent for households making over $1 million during the taxable year.
- Eliminate the basis step-up for property passing from a deceased taxpayer[xiii] if the gain inherent in the property at the time of death (the built-in gain) exceeds $1 million (or $2 million in the case of a deceased married couple[xiv]).
- Tax the built-in gain of a decedent’s assets (including their equity interest in a closely held business) as if they had been sold at the time of death for an amount equal to their fair market value – a one-time mark-to-market tax – unless the asset is a family-owned business that is passed to the owner’s heirs,[xv] provided the heirs continue to run the business.[xvi]
- Eliminate the like kind exchange[xvii] for real property where the gain realized exceeds $500,000.[xviii]
It is noteworthy that the President’s plan is silent regarding the federal estate tax.
It appears, therefore, that the estate tax[xix] will continue to apply in its current form, which includes an $11.7 million per person exemption (based upon a 2010 basic exclusion amount of $10 million, adjusted for inflation), portability of the unused exemption between spouses, and a top tax rate of 40 percent.
That is to say, the estate tax shall be imposed upon a taxable estate notwithstanding the imposition of the mark-to-market gains tax. The two taxes will not be mutually exclusive.[xx]
Of course, under the terms of the Tax Cuts and Jobs Act,[xxi] the basic exclusion amount is scheduled to return to $5 million per person in 2026.
However, candidate Biden often spoke about accelerating the reduction of the basic exclusion amount to its pre-2018 level. If President Biden does not act to do so before the mid-term elections in November 2022, he may lose his opportunity if the Democrats lose even one seat, on a net basis, in the Senate.[xxii]
Anyone who expected, or at least hoped, that Mr. Biden would elaborate upon some of these proposed changes in his speech to Congress was disappointed. Instead of any substantive discussion, they were treated to soundbites, many of which, at best, must have been derived from an incomplete – or inconvenient – set of facts. For example:[xxiii]
“. . . it’s time for . . . the wealthiest 1 percent of Americans to just begin to pay their fair share. Just their fair share.
“. . . I think you should be able to become a billionaire or a millionaire. But pay your fair share. . .
“We’re going to reward work, not just wealth. We take the top tax bracket for the wealthiest 1 percent of Americans, those making over $400,000 or more, back up to . . . 39.6 percent.
“We’re going to get rid of the loopholes that allow Americans to make more than $1 million a year and pay a lower tax rate on their capital gains than Americans who receive a paycheck . . .”
“The I.R.S. is going to crack down on millionaires and billionaires who cheat on their taxes . . .”[xxiv]
Someone listening to Mr. Biden’s presentation might think that wealthy Americans are adept at shirking their federal tax obligations “left, right and center” (to adapt a line the President used a couple of items last Wednesday), while their “fellow Americans,” who are less well-off, bear the burden of funding the government and the many services and benefits it provides.
Do the Wealthy Pay Tax?
When was the last time you searched the internet for information regarding the allocation of federal income taxes among various economic classes? If you cannot recall, I suggest you take a few minutes to check it out. I will wait for you.[xxvi]
Tick, tock, tick, tock.
Time’s up. What did you find?
That the top 1 percent of taxpayers earned 20.9 percent of all adjusted gross income and paid 40.1 percent of all individual income taxes, as compared to 28.6% for the bottom 90 percent combined, and as compared to 3 percent for the bottom 50 percent? That the top 1 percent of taxpayers paid a 25.4 percent average individual income tax rate, which is more than seven times higher than taxpayers in the bottom 50 percent (3.4 percent)? That the top 50 percent of all taxpayers paid 97.1 percent of all individual income taxes, while the bottom 50 percent paid the remaining 2.9 percent?[xxvii]
Does Charitable Giving Count?
When you have some time, you may also want to check on the level of charitable giving by wealthy donors – think of it (as I do) as a form of “voluntary tax” in that it represents the dedication of private funds to the promotion of desirable public or societal goals. Such charitable contributions ultimately lessen the burden of government.[xxviii]
You will find that the top one percent account for approximately one-third of all charitable dollars given for any taxable year. They are also responsible for approximately 80 percent of charitable donations made at death.
Query whether any of the foregoing data will inform the decision-making in Congress? Query to what degree it even should.
Regardless, it seems that a new chapter has been opened in the national discussion over taxes and tax policy, the primary catalyst for which was the economic downturn caused by our efforts to contain the pandemic, and its disparate effects upon different segments of our population.[xxix]
The notion of what constitutes one’s “fair share” is now being defined expressly by reference to how much the government thinks one can afford to pay – basically, “from each according to his ability.”[xxx]
One can debate both sides of this principle for decades, even centuries – indeed, we already have. Setting aside the political/philosophical debate, however, and assuming the Democrats can stick together long enough to successfully enact some version of Mr. Biden’s proposals using the reconciliation process, what are the practical implications for business owners?
At this point, it is difficult to say. As indicated throughout this post – including the endnotes[xxxi] – there are many open questions regarding the substantive terms of the proposed changes.
Perhaps as important, neither the White House’s summary nor the President’s speech gave any indication of when these changes, if enacted, would become effective; specifically, there was no mention of giving retroactive effect to January 1, 2021 for any of the changes, nor was there any reference to a January 1, 2022 start date.
That said, Speaker Pelosi has stated that the American Jobs Plan and the American Families Plan would probably be packaged as two separate bills,[xxxii] with the first (the infrastructure bill) being ready for the Senate by July 4 and being enacted in August.[xxxiii] Thus, the Families Plan (along with its tax changes) would likely be enacted during the fall. Considering this timeline, and how late in the year the legislation may pass, Mr. Biden’s tax proposals will probably become effective on the date of enactment, or on January 1, 2022, or some combination of the two.
Planning for Death
That is not to say, however, that the owner of a closely held business should passively bide their time until the details of the President’s tax plan have been developed, vetted, revised, and released during the summer or early fall.
For example, the owner and their advisers may have determined that the owner’s estate, which includes the fair market value of their business, will not be subject to the 40 percent federal estate tax as presently constituted. However, the loss of the basis step-up, coupled with the deemed sale[xxxiv] of the business upon the death of the owner, may result in the imposition of a 39.6 percent income tax on that portion of the gain in excess of $1 million that is thereby “realized” by the estate. In other words, it would behoove the owner’s estate to reduce the amount realized to the greatest extent possible by being able to substantiate the owner’s adjusted basis for the business – the necessary recordkeeping should be performed by the owner today, not by the executor of their estate later.
Will the estate be prepared to satisfy this income tax liability, which may include not only federal tax, but state tax as well if the states conform to the federal changes? Will there be enough liquidity in the estate – such as insurance on the life of the deceased owner – or will estate assets have to be sold or leveraged? What if the decedent’s gross estate includes non-probate assets? Would some sort of contribution be helpful?
What if the decedent’s estate is subject to both the 40 percent estate tax on the net fair market value of the business – because of a reduced exemption amount, or perhaps because of adjustments to the value of the business following an IRS audit[xxxv] – and the 39.6 percent income tax on the built-in gain arising from the deemed sale of the business? That could add up to a lot of tax.
The business owner and their advisers should start thinking about, and planning for, these and other scenarios. A simple first step: because the President’s tax plan does not address the estate and gift tax, a taxpayer who is already inclined toward making gifts[xxxvi] or otherwise removing appreciating assets from their future estate, may want to proceed with these plans – doing so would remove value from the estate for purposes of both the estate tax and the proposed mark-to-market tax at death.
Planning for Sale
What about a business owner that is considering the relatively near-term sale of the business?
It may behoove them to sell the business as soon as practicable, while the current, lower rate for long-term capital gains is in effect, provided it makes sense from a business perspective to do so. If the consideration for the sale is to be paid in installments – for example, as in the case of a promissory note or an earn-out – the owner may want to consider electing out of installment reporting if doing so will subject the gain from the sale to tax at the lower, current rate. Such an election must be made on or before the due date (including extensions) for filing the owner’s tax return for the taxable year in which the sale occurred.[xxxvii]
A taxpayer who is just starting out in a business, or who operates a business through a sole proprietorship or as a partnership with others, may want to consider incorporating the business if the corporation will be a “qualified small business” and if the owner’s stock will be treated as “qualified small business stock,” the gain from the actual or deemed sale of which will be excluded from gross income.[xxxviii]
A lot can happen between now and the final version of Mr. Biden’s tax plan.
The President and the Democratic Congressional leadership may be hard-pressed to keep the members of their own party in line (especially in the Senate), let alone persuade any Republicans that the tax changes proffered make sense from any perspective.
In that case, it is very likely that many of the President’s proposals will have to be diluted to secure the requisite number of votes within his party. For example, rate hikes may have to be reduced, certain provisions may have to be phased in over time, and others may have to be traded away in the process of negotiating a passable bill.
The next month or two will be critical to the evolution of the tax provisions in the American Families Plan. Business owners and their advisers will have to be vigilant in following developments in Washington and vocal in making their opinions known to their Congressional delegations. They will also have to be prepared to act quickly if necessary.
As always, there should be a bona fide business or “personal” reason that serves as the principal motivation for the owner’s decision. Taxes should be considered insofar as they may affect the net economic result of that decision. If the owner understands these basic rules, and plans their response to possible outcomes accordingly, they will be in a good position to either weather the tax storm or get out of it.
[i] Did you notice Senators Manchin and Romney in the nosebleed sections, rather than on the Chamber floor?
[ii] One would normally expect more than 1,000 attendees for such an occasion.
Interestingly, Reuters observed that Mr. Biden’s “audience slumped nearly 44% below the TV viewership” for Mr. Trump’s first address to a joint session of Congress (in 2017), which attracted approximately 47.7 million viewers.
[iv] Dubbed “The Made in America Tax Plan.”
[vi] I am vexed by how often a provision of the Code is characterized as a loophole. I have always understood the word “loophole” to mean some ambiguity in the law that may be used to avoid the purpose of the law.
There is nothing ambiguous about the taxation of long-term capital gain under the Code.
[vii] There are others. See https://www.rivkinradler.com/publications/tax-highlights-the-american-families-plan/ .
[viii] Or from 40.8% to 43.4% with the 3.8 percent federal surtax on net investment income under IRC Sec. 1411. The surtax does not apply to an owner’s share of partnership or S corporation business income if the owner materially participates in the entity’s business. IRC Sec. 1411(c), Sec. 702, and Sec. 1366.
Query at what level of taxable income this top rate will become applicable. What will the final bracket look like?
[ix] From the sale or exchange of capital assets, or of certain business assets, held for more than one year. IRC Sec. 1221, 1222, 1223, and 1231.
[x] For example, a distribution of cash by an S corporation that exceeds the corporation’s AAA and the shareholder’s adjusted basis for their stock. IRC Sec. 1368.
[xi] In the case of partners or S corporation shareholders who materially participate in the entity’s business, the rate will be increased from 20% to 39.6% on the long-term capital gain from the disposition of their equity in the business and on their share of the long-term capital gain from the entity’s disposition of its assets.
[xii] IRC Sec. 1(h)(11). Of course, from the perspective of the corporation making the dividend distribution, the amount of the dividend is an after-tax amount – the corporation has already paid income tax thereon; at the current flat rate of 21% (a combined corporate/shareholder rate of almost 40%), or at the proposed rate of 28% (a combined corporate/shareholder rate of more than 45%).
[xiii] IRC Sec. 1014.
[xiv] Query whether a rule similar to “portability” in the context of the estate tax will apply for this purpose. For example, if the assets of the predeceasing spouse have less than $1 million of built-in gain, will the remaining portion of the predeceasing spouse’s $1 million “exclusion” be added to the surviving spouse’s $1 million exclusion for purposes of determining the amount of gain to be recognized upon the death of the surviving spouse?
[xv] Presumably named as beneficiaries of the owner’s will or trust, or perhaps even under the terms of a shareholders’ or partnership/operating agreement.
[xvi] IRC Sec. 1001.
Big question: will the States conform to these federal changes?
[xvii] IRC Sec. 1031.
[xviii] What is the most reasonable way to interpret this? Will a taxpayer be allowed to use a like kind exchange to defer up to $500,000 of total gain every taxable year (regardless of the number of transactions engaged in)? What if the seller is a partnership or (heaven forbid) an S corporation? In that case, the limit should be applied at the level of the partner or shareholder. This may provide some planning opportunities.
Interpretations aside, what tax policy underlies the proposed change? According to Reg. Sec. 1.1001-1, the gain or loss realized from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained. Focus on “differing materially” in kind. In the absence of such an exchange, the gain realized should not be treated as income. The same principle underlies the corporate reorganization rules. At what point will these rules be deemed so inconvenient or costly as to justify their elimination to generate more tax revenues?
[xix] Along with its supporting cast of “transfer taxes”; i.e., the gift tax and the generation skipping transfer tax.
For a discussion of Mr. Biden’s earlier plans for the estate tax, please see my article on the internet at https://www.taxlawforchb.com/2021/01/the-federal-estate-tax-in-2021-what-might-we-expect-what-can-we-do/ .
[xx] Query whether the latter will be deductible for purposes of determining the estate tax. I think it should but see Reg. Sec. 20.2053-6.
[xxi] Pub. L. 115-97.
[xxii] Not a remote possibility.
[xxiv] Amen to that. But why limit efforts to “recognized” millionaires and billionaires? Cheating is cheating – the dollars collected, and the cathartic effect on the public, are just as tangible.
Other questions abound. For example, is the $400,000 a per-person limit or a per-household limit? Can a family making $400,000 per year in an expensive city be characterized as “rich”? Hardly.
If the President is concerned about investment income – specifically long-term capital gain and qualified dividends – then why include a taxpayer’s ordinary compensation income in determining the $1 million threshold? After all, it is already taxed at the top income tax rate. The same is true for the taxpayer’s share of ordinary business income generated by a partnership or an S corporation.
[xxv] Guess it was just a phase.
[xxvi] No, this is not a Mumford & Sons tribute. (Tell me you are not surprised I knew who they were.)
[xxvii] The findings of the conservative-leaning Tax Foundation, the “neutral” Congressional Budget Office, and the liberal-leaning Tax Policy Center are generally aligned.
[xxviii] In recognition of this fact, the Code seeks to foster charitable giving by allowing taxpayers to deduct qualifying contributions in determining their income tax liability. IRC Sec. 170, Sec. 2055, and Sec. 2522.
[xxix] You have heard it many times already: as people at one end of the socio-economic spectrum lost their jobs, their homes, their ability to feed and care for themselves, those at the other end were able to continue working (albeit remotely); not only that, they were able to refinance their debt and even purchase second homes thanks to the Fed’s interest rate policy – all while their investment portfolios (including qualified retirement funds) experienced record highs.
[xxx] Funny, isn’t Karl Marx credited with having coined that phrase? Indeed, he is. It is followed by “to each according to his needs.” That is a poor business model – one that rewards mediocrity and sloth, and that ultimately drives away talented or hardworking individuals.
I highly recommend the following piece on FDR: https://www.politico.com/magazine/story/2019/08/16/democrats-socialism-fdr-roosevelt-227622 . Some have said that he successfully co-opted, and thereby undermined, the socialist movement in America during the 1930s.
[xxxi] Don’t skip the endnotes.
[xxxiv] In the case of a partnership, the consideration for the deemed sale of the decedent’s partnership interest should include the decedent’s share of partnership liabilities under IRC Sec. 752.
In addition, the deemed sale of the decedent’s partnership interest should be treated the same as an actual sale for purposes of making the Section 754 adjustment to the estate’s share of the partnership’s inside basis.
[xxxv] At the inception of such an audit, the estate may want to file a protective refund claim for the estate tax paid, assuming the income tax on the gain from the deemed sale is deductible.
[xxxvi] Especially if some portion of their exemption amount remains unused.
[xxxvii] IRC Sec. 453(d). Of course, the gain from the sale of certain assets does not qualify for installment reporting; for example, the gain attributable to depreciation recapture.
For a more detailed discussion regarding the proposed tax increases and the sale of a business, please see https://www.rivkinradler.com/publications/bidens-proposed-income-tax-increases-and-the-sale-of-the-baby-boomer-business/ .
[xxxviii] IRC Sec. 1202. Please see my article on the internet at https://www.taxlawforchb.com/2020/11/the-loss-of-the-favorable-capital-gain-rate-the-exclusion-of-gain-under-section-1202-and-the-incorporation-of-the-partnership/ .
Query whether qualified opportunity zones will become more attractive to taxpayers who have sold their business and who are looking for a way to defer and reduce their tax liabilities? See my article on the internet at https://www.taxlawforchb.com/2019/02/sale-of-a-business-and-qualified-opportunity-funds-deferral-exclusion-and-risk/ .