September 21, 2020

Written by Bruce Paulson, CPA, JD, CFP®, Senior Client Advisor and Jennifer Arps, CFP®, Senior Client Advisor

The Biden tax plan, as you know, is released and receiving much commentary pre-election. Understanding that planning is difficult until we know the election outcome and the law, our comments on the tax plan are below. I hope you find the discussion useful, and we welcome any questions. Should you be interested, the MRA Associates (MRA) blog contains articles on many of these subjects.

Tax Law Changes

The proposed tax law changes include:

• Increasing top individual tax rate on income > $400,000 to 39.6%
• Social Security tax on income > $400,000 subject to 12.4% supplemental Social Security tax, evenly split between employers and employees
• Dividends and all capital gains when income is > $1,000,000, taxed at 39.6%
• Itemized deductions – Caps tax benefit of itemized deductions at 28%
• Deduction of state-local taxes ($10,000 cap) - gone
• Like-kind exchange (“1031 rollovers”) - repealed for income > $400,000
• Top corporate income tax rate – increase from 21% to 28%
• Estate taxes
  • Exemption amount - unclear, but less than the current amount ($11.58M per person)
  • Rate - no change: 40%
  • Removal of income tax basis step-up -stated current plan is to tax unrealized asset appreciation at death

Family Wealth Planning Implications

Use of Estate Tax Exemption

Use it or risk losing it. Now is the time to talk to your advisors about making a gift before year-end, which could take different forms (e.g., direct transfer, transfer to a new or existing trust, or forgiveness of an intra-family/entity note receivable). The income tax tradeoffs that come with most gifts are important, especially for taxpayers who are older, hold assets with low-income tax basis, and live in high tax states, such as Minnesota.

Charitable Remainder Trusts (CRT)

Taxpayers making over $1,000,000 who receive payments from CRTs will pay higher income tax on the portion of their trust payments treated as dividend or long-term capital gain. As advisors know, distributions from a CRT are governed by so-called “tier rules” that cause trust distributions to consist first of ordinary income, then capital gains, followed by other income, and last, trust corpus. Thus, CRT portfolios are often managed to keep highest taxed income (e.g., ordinary income, short-term capital gains) low compared to lower taxed income (e.g., dividends, long-term capital gains), as highest tax rate income realized always comes out before lower taxed income.

If long term capital gains (LTCG) are a high percentage of the annual trust distribution, and the tax rate on LTCG increases, look at creating a separate account equity index (SAEI) solution outside the CRT to systematically harvest tax losses that will eliminate or reduce the tax upon the trust distribution. Perhaps better yet, look at placing the SAEI inside the CRT, where both the duration and benefit from tax loss harvesting could be far higher than if held outside.

Charitable Lead Trusts (CLT)

Charitably minded families who a) are in top federal/state income tax brackets, b) face the new 28% itemized deduction rate cap, and c) have assets that generate the highest taxed income may benefit from funding a non-grantor CLT, a new taxpayer. The trust, we believe, could be drafted to include in trust accounting income both realized short and long-term capital gains. This income, while taxable to the trust, should receive each year an offsetting income tax deduction for amounts paid to charity. State fiduciary laws, here, are important; they differ in defining what is and is not trust accounting income.

Income - Defective Grantor Trusts

The Biden Administration has not (yet) targeted the significant, long-term benefit of parents (grandparents) paying the income tax liabilities on assets residing in trusts that are sheltered from estate tax. If income is taxed at 43% plus and the investment (still) makes pre-tax sense, owning the asset in an income defective grantor trust rises in appeal if the grantor has the cash flow to pay the trust’s income tax liabilities.

Grantor Retained Annuity Trusts (GRATs)

There is nothing, to our knowledge, on the table to repeal or impact GRATs, but if the Democrats win the Senate, anything could happen. Families that are thinking of funding a GRAT might consider doing so now to avoid the risk of gift and estate tax laws changing to their detriment. While short-term (“rolling”) GRATs, for good reasons, are often favored, consideration might be given to funding a longer term GRAT to take advantage of record low interest rates and to eliminate the risk that GRATS could be repealed in coming years.

Installment Sale to Income-Defective Grantor Trust 

As with GRATS, there is no proposal that we know of to repeal or impact this type of transaction. Recall, though, that President Obama’s budget proposal in 2015 included a provision that (in essence) attacked sales, exchanges, or comparable transactions between a grantor and his or her grantor trust, intending that these assets would be included in the grantor’s estate at death or subject to gift tax on certain events during the grantor’s life.

Again, families who are considering the installment sale may wish to do so before year end. Higher interest rates in the future pose investment challenges, but they create a potential estate tax opportunity. Remember, the seller holds a fixed rate note receivable, often interest only with a balloon payment at the end. If the seller dies before the note is paid off, the fair market value of the note is included in his or her estate. If interest rates have risen from the time of the transaction (e.g., from 1% to 4%), both Treasury regulations and case law hold that higher interest rates are one reason to value the note in the estate at an amount less than the outstanding principal balance.

Section 1031 Exchanges

Biden proposes to eliminate “like-kind” exchanges for investors with annual incomes of more than $400,000. A few thoughts:

• If a family wishes to reduce real estate exposure, selling in 2020 may be appropriate if a plan exists, anyway, to sell real estate in the next several years (when the LTCG rate may be higher).
• If a family wants to sell real estate and reinvest back into real estate, a 1031 rollover may or make not make sense. Remember, with a 1031 exchange comes carryover of income tax basis: hence, lower depreciation deductions in future years. If income tax rates rise, depreciation deductions (offsetting rental income) rise in value.
• Opportunity zone investments and UPREIT transactions are two other ways to sell real estate and defer (or possibly eliminate) the income tax liability. Pros and cons exist with each and both involve fees – some not obvious or transparent.

Tax on Unrealized Gains at Death

This proposal raises a whole new can of worms. Most commentators do not feel this proposal will pass and exist side-by-side with an estate tax. With that said, families with grantor trusts that use their trust powers of substitution/acquisition to pull low-income tax basis assets back into their estate may think twice about this. Doing so (under the new law) could accelerate income tax on a deferred liability that, if left alone, could be deferred for many years. Instead, trust powers might be used to bring the highest basis assets back into an estate.

Pay Gift Taxes

Families who foresee: a) higher federal and state taxation of wealth and b) new laws that trim ways to reduce or shelter wealth from estate tax (e.g., GRATs, note sales, grantor trusts, valuation discounts, etc.) may look more seriously at paying gift tax. Doing so removes gift tax dollars from exposure to estate taxes, shelters future asset growth from estate tax exposure, and shelters assets from (under Biden proposal) earlier-than-desired payment of income taxes on unrealized capital gains. Grantor trusts would seem natural recipients of large taxable gifts, allowing the grantor to continue paying income taxes for the trust beneficiary. The income tax basis of the gifted asset should receive an upward adjustment for gift taxes paid (up to the market value of the asset), but families should check with their tax advisor on this, especially when the asset lands in a grantor trust.

Corporate Stock Redemptions

Private business owners that are or may be redeeming corporate stock in 2021 may wish to accelerate taxable stock redemptions into 2020. We mention this because whether the corporation is taxed as a C corporation or S corporation, distributions that are taxed as either dividends or long-term capital gain face an increase in tax under the Biden administration from 23.8% to 43.40%.

Investment Implications

Hedge Funds

Hedge fund investors with income above $1,000,000 will see their tax on LTCGs rise dramatically from 23.8% to 43.4%. Most impacted will be funds where the taxable turnover is high and mostly long term in character. Active investment managers (funds or other) whose tax-control efforts rest solely on holding stocks more than 12 months to capture LTCG treatment may need to revisit their stock selection and trading policies to support any claim of being tax-efficient. Please see Exhibit A.

Two old, but still relevant points merit mention:

• Look at the benefits of pairing tax-generating hedge funds with SAEI solutions that harvest tax losses, which offset otherwise taxable long and short-term capital gains.
• Own tax-generating hedge funds in tax-friendly locations (e.g., IRAs, grantor trusts, other trusts) across the family balance sheet.

Active vs. Passive Equity (Net After-Tax)

The oft-vociferous debate continues, as most active managers continue to underperform their respective benchmarks. If dividends and long-term capital gains are taxed at 39.6%, most active managers who favor dividend-paying securities and (to repeat) freely realize LTCGs will need to generate a higher pre-tax return to earn their keep when compared to most passive equity solutions, at least where deferral of income tax is measured over a long (e.g., ten years plus) period of time.

Separate Account Equity Index (Value of Systematic Tax Loss Harvesting)

For investors with income above $1,000,000, the value of systematic tax loss harvesting that comes from using a separate account equity index portfolio increases in potential value[1]. It could be families who use mutual funds or exchange-traded funds to capture passive equity exposure would benefit from selling these funds and starting their own separate account equity index portfolio. Whether this makes sense or not will depend upon different factors. Please see Exhibit B.

Families with: a) appreciated assets that might be sold in the near future, b) actively managed portfolios generating either short- or long-term capital gains, and c) an upcoming capital gain event (e.g., sale of a business or stock redemption), could well benefit from creating their own, separately managed equity index portfolio to harvest tax losses that, carried forward, would eliminate or reduce tax at 43.40% (vs. 23.8% under current law).

Actions to Consider Before Year End

In terms of actions to consider before year-end, a few come to mind for families who may be impacted by the Biden tax proposals:

Income Tax

• Accelerate tax on long-term capital gains into 2020 IF:
  • Your taxable income is greater than $1,000,000
  • You “otherwise” will realize this gain and pay income tax in the next several years

• Re-evaluate the timing of charitable contributions into 2020
  • Would your tax rate benefit be higher before or after a tax law change?
  • 100% AGI “cap” for cash contributions to “qualified charities” ends this year
  • Biden plan would “cap” the rate benefit to 28%

• Re-evaluate the timing of certain state tax payments
  • Defer payment of fourth quarter estimated tax payments into 2021
  • Defer payment of property taxes (as possible) into 2021

• Consider ROTH IRA conversion
  • Multi-year income analysis is even more valuable
  • The value of a ROTH IRA conversion increases for a taxpayer anticipating a future estate tax liability

• Employee-related equity-compensation elections
  • If an opportunity exists to accelerate vesting of restricted stock income into 2020, and receipt of same in 2021, 2022, 2023, etc. will push income above $1,000,000 threshold, consider doing so.
  • If elections exist before year end to defer 2020 bonuses into future years, and receipt of income (in 2021) would cause income to be above $1,000,000, look at doing so. Deferral of 2020 bonuses gets tricky and depends upon the facts.

Estate Tax

• Use “at-risk” estate tax exemptions.
  • Look at different ways to do this
  • Make sure you understand the income tax trade-offs
  • Do not wait until November to start your planning

• Consider certain proactive actions, preparing for “the worst” tax outcome.
  • GRATs - If otherwise under consideration, look at funding before year end
  • Installment Sales – Likewise, if under consideration, look at the transaction more carefully before year end
  • Grantor trusts
    • Evaluate now where you want highly appreciated assets to reside across the family balance sheet (e.g., If Biden built-in-gain tax comes to pass)
    • If trusts are not grantor trusts, look now at the pros and cons of making them so before year end

 

Exhibit A – Hedge Funds

If we assume 10% gross return, 1% fee, 15% net incentive, .40% other costs, and 100% taxable turnover and all of it being long term in nature, you see below how a long-long short manager is impacted even if gains are long term in nature. A taxable turnover number of 100% is unrealistic, as is 100% of that turnover being long term in nature. It is offered to illustrate a point: keeping gains long term in nature, alone, is no longer enough for an active manager to claim he or she is tax efficient.

 

Exhibit B – Value of Tax Loss Harvesting

Current Tax Law

Biden Tax Proposal – Taxpayers with taxable income > than $1,000,000

The tax loss numbers are estimates. They should not be relied upon in making any decision. Please read footnote one (Aperio article) for discussion of how the Biden tax proposal impacts tax loss harvesting.

 

 

[1] If you aren’t clear on what a separate account equity index is and how it differs from a retail index fund (or exchange-traded fund), I encourage you to read this piece, https://www.mraassociates.com/do-tax-harvesting-solutions-deserve-a-place-in-your-passive-or-active-portfolio,  and the excellent recent piece by Aperio Group, https://www.aperiogroup.com/blogs/impact-of-bidens-capital-gains-proposal-on-the-performance-of-loss-harvesting-strategies.

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