November 7, 2020
With Biden Announced as President-Elect, Consider These Last-Minute Tax Planning Ideas
Posted by Pam Dennett
2020 will no doubt go down in history as one of the most chaotic and unpredictable years ever. Now that Biden has been announced as the President-elect, we must be prepared for upcoming legislative changes to the tax laws. However, since the Republicans will likely remain in control of the Senate, the extent of new tax legislation is unknown at this point.
Biden will likely need to compromise on many aspects of his tax plan. But, waiting until new legislation is passed could be costly to wealthy taxpayers, since the changes could be retroactive to January 1, 2021. Below we will look at income and estate tax planning opportunities to consider before the end of 2020 and beyond in an environment when taxes will likely increase.
First, here’s a quick recap of the tax plan Biden proposed during the campaign, which included the following changes applicable to individual taxpayers:
|Tax Policy Issues||Current Law||Biden Tax Proposal|
|Tax rate on ordinary income||Top marginal rate is 37% until 2026 (if current law expires, top marginal rate reverts to 39.6% beginning in 2026)||Restore top marginal rate to 39.6% for taxpayers with over $400,000 of taxable income (it’s not clear as to how this relates to filing status)|
|Tax rate on long-term capital gains & qualified dividends||0% rate (income between $0 and $78,750)|
15% rate (income between $78,751 and $488,850, MFJ)
20% rate (income above $488,851, MFJ)
|Tax capital gains and dividends at 39.6% for taxpayers with over $1 million of taxable income (and potentially for all taxpayers)|
|Tax rate on carried interests||If held at least 3 years, taxed at long-term capital gain rates||Tax as ordinary income|
|Itemized deduction cap||Itemized deduction limit repealed (the current law expires in 2026 and the “Pease” limitation is reinstated)||Cap value of itemized deduction at 28% (rather than the then-top 39.6%), and reinstate the Pease limitation for those with income above $400,000|
|High-income Social Security payroll tax||No Social Security payroll tax on income above $137,700 (indexed)||Expand the 12.4% (6.2% for the employer and 6.2% for the employee) Social Security payroll tax to income in excess of $400,000|
|Pass-through trade/business income (§ 199A)||20% deduction||Implement a new phaseout for income over $400,000|
|Estate tax||40% estate, gift and generation-skipping tax; basic exclusion is $11.58 million in 2020 (continued indexing); expires at the end of 2025||Return the exclusion to pre-TCJA amount of $5.49 million as adjusted for inflation (or possibly down to $3.5 million for the estate tax exclusion and $1 million for the gift tax exclusion). Increase the tax rate from 40% to 45%. Repeal stepped-up tax basis at death.|
Income Tax Planning Before the End of 2020 and Beyond
Certain taxpayers can expect an increase in federal income tax effective as early as January 1, 2021, and potential increases in some state taxes (such as state income tax, real estate tax, sales tax, etc.). Below are suggestions to consider for 2020 year-end tax planning and beyond.
1. Timing of income. With income over $400,000 potentially moving from the 35% and/or 37% marginal brackets as high as a 39.6% marginal tax rate, consider accelerating income that would fall into those lower brackets into 2020 and deferring deductions that could provide a more valuable shelter for income at a higher rate in future years. Some of the items of income taxpayers might have control over include the timing of bonuses, exercising stock options, consulting or self-employment income, and retirement plan distributions.
2. Itemized deductions. Under the Biden plan, there may be a cap applied to itemized deductions at 28% and those deductions could be further limited for taxpayers with income above $400,000 (the Pease limitation returns). With income tax rates likely going up, consider deferring deductions to next year to use against income that will be taxed at higher rates. The $10,000 limit to deduct taxes applies to sales tax, state income tax, and/or real property tax. It is unclear if this limitation will remain under the Biden plan. If you have met your tax limit of $10,000 in 2020 from total “sales” tax and/or state income tax, consider the deferral of real estate tax to 2021.
Taxpayers may want to consider holding off on year-end charitable contributions and making them in January 2021 so they offset income that is taxed at higher rates. However, if the Pease limitation returns, some of the charitable contributions could be limited and would then need to be carried forward. Charitable contributions that are limited may be carried forward for five years.
3. Consider “gain harvesting.” Most of us have heard the term “loss harvesting,” where we ask our investment advisors to look for securities in our portfolios that might make sense to sell, from an investment perspective, and will generate losses to offset capital gains we have realized during the year. With a potential increase in the capital gains tax, “gain harvesting” is something to consider before the end of 2020. If you have large concentrations of low-basis stock, this might be a year to consider realizing some capital gains before the tax rates increase. If the stock is meaningful and you want it in your portfolio, you can buy it back right away with a new higher tax basis. You do not have to wait 30 days to buy it back as you would if you sold the security at a loss.
If you do have losses in your portfolio, it may make sense to defer recognizing losses to future years to allow for the offset of future capital gains at the higher tax rate. Gifting appreciated securities to lower income individuals will become even more attractive, as they may incur half the tax liability upon sale.
4. Charitable planning. Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020, individuals making cash gifts directly to qualified charities can claim a deduction of up to 100% of their adjusted gross income, basically eliminating their income tax liability for 2020. If you have made charitable pledges, consider funding those pledges in 2020 to take advantage of the once-in-a-lifetime unlimited charitable contribution deduction using cash. Keep in mind, you need to review the impact this has to any charitable contributions that are being carried over from prior years, particularly if those carryovers involved gifts of capital gain assets which have lower limits on deductibility. Also, you should weigh the benefit of using charitable contributions to reduce income tax in 2020 with the impact of using the deduction in future years against income taxed at higher rates.
5. Required minimum distributions in 2020 are waived. Under the CARES Act, required minimum distributions (RMDs) for IRA account owners who are more than 70 ½ years old have been waived. Individuals who are typically required to take an RMD may want to consider passing this year to avoid payment of the income tax on the distribution if they do not need the cash flow. If you have already taken the RMD for 2020, the deadline to return the distribution was August 31, 2020, so you cannot return the money. If you will have income over $400,000 next year, you may want to go ahead and take your RMD in 2020 while you are subject to lower income tax rates.
6. Converting an IRA to a Roth IRA. Many taxpayers have already taken advantage of converting their traditional IRAs with depressed values to Roth IRAs during 2020. All future appreciation and earnings will grow income-tax-free for the life of the Roth IRA. If you have already made the conversion in 2020, consider increasing charitable contributions this year to offset the income tax liability associated with the Roth IRA conversion. The combination of a conversion of an IRA to a Roth IRA with increased charitable contributions has the potential to eliminate the income tax hit on the IRA conversion. Taxpayers who are still considering a conversion may have more reason now to do it before the end of the year with future income tax rates on the rise.
7. If selling a business before the end of 2020, elect out of installment sale treatment. Many taxpayers in the process of selling businesses are pushing to have the sale closed before the end of 2020. Most sales of businesses must be treated as installment sales because the total proceeds are paid out over several years and subject to tax in the year the proceeds are received. Many deals require a hold-back of funds in escrow and/or earn-outs, which will be subject to income tax in future years. For a deal that closed in 2020, consider electing out of “installment sale treatment,” which will tax the entire transaction in 2020 versus in years when the income tax rates may potentially be much higher. You should discuss this with your tax advisor, to understand the pros/cons.
8. The rise of the charitable remainder trust (CRT) in 2021 and after. In an environment with low capital gains tax rates, the CRT is less attractive. If capital gains tax rates increase to possibly 39.6% for some taxpayers, the CRT will become a popular vehicle to defer capital gains over a term of years or even a lifetime. A CRT can provide for deferral of capital gains, an income stream to a taxpayer, and an upfront income tax charitable deduction.
A taxpayer may contribute a low tax basis asset to a CRT and then have the CRT sell the asset. Since the CRT is not subject to income tax, the capital gains resulting from the sale of the asset are not immediately subject to income tax. Each year, the taxpayer will receive an income stream, for a term of years or for the remainder of their life. Income taxes are paid on the income stream as it is received, which results in the original capital gains being deferred over the term of the CRT, resulting in the immediate ability to invest 100% of the proceeds from the sale into other assets. The taxpayer also receives an income tax charitable deduction in the year the CRT is created equal to the present value of the remainder interest that will pass to charity at the end of the term of the CRT.
9. Moving to a no-income-tax state. As many states continue to struggle with long-term fiscal imbalances and the potential for increased state taxes, many taxpayers have successfully “moved” out of a high-income-tax state into a no-income-tax state without being harassed by the former taxing state. It is important to understand the rules of each taxing state with regards to both domicile and residency, which may have different meanings depending on the state. If you plan to make a move, be sure to work with a tax advisor who understands the rules of the multiple states involved.
Estate and Gift Tax – Why You Need to Act Now
The 2017 Tax Cuts and Jobs Act (TCJA) changed the estate and gift tax regime by increasing the amount of assets an individual may pass to their heirs tax-free (referred to as the “lifetime exemption”). The amount of assets (lifetime exemption) that can pass without being subject to the 40% estate/gift tax for 2020 is $11.58 million per person ($23.16 million for a couple). Under the current law, the lifetime exemption will be adjusted for inflation to $11.7 million per person ($23.4 million per couple) for 2021.
Biden has suggested a repeal of the TCJA provision relating to estate tax, which would return the lifetime exemption to approximately $5.49 million as adjusted for inflation or possibly reduce it even further to $3.5 million per person for estate tax and $1 million per person for gift tax. Also, the tax rate could be increased from 40% to 45%. This change could be retroactive to January 1, 2021.
Biden also suggested repealing the current law that allows for assets to be either stepped up or stepped down to the fair market value as of the date of death, resulting in a new tax basis. In other words, a decedent’s heirs would take the same tax basis as the decedent had prior to death. This would have a big impact on families who have been planning on passing low basis assets at death. Without the step up in basis, there will be capital gains when those assets are disposed of, and under the Biden plan, those capital gains could now be taxed at the top marginal tax bracket of 39.6% for taxpayers with taxable income over $1 million.
Even if the new administration does not change the estate tax laws right away, the current estate and gift tax regime is temporary and currently set to expire on January 1, 2026, which will result in a decrease of the lifetime exemption to approximately $6 million per person as adjusted for inflation.
Estate Planning Before the End of 2020
With so much information in the media and on the internet, it can become overwhelming and difficult to make any kind of decision on what the focus of 2020 estate and gift tax planning should be given the short amount of time left in the year. Below is our list of the top considerations to focus on:
1. When we say use it or lose it, we mean it! Our number one suggestion right now is to use the increased lifetime exemption before you consider any other technique. This can be done by making outright gifts or gifts to trusts. As a potential added benefit, if assets are transferred to a holding company such as an LLC prior to being gifted, it may be possible to gift interests in the LLC outright or in trust at discounted values. Below are some suggestions to use the exemption making outright gifts to individuals or gifts to be held in trust for individuals:
- Gifts of cash or marketable securities
- Gifts of partnership interest at a discount
- Gifts of S corporation stock or C corporation stock (including qualified small business stock) at possible discounts
- Gifts of real estate (be careful if located in CA for property tax reassessments)
- Forgive an intra-family note receivable
- Sell an asset at a below market rate, which will result in part gift/part sale
- Gift tangible personal property such as collectibles (art, cars, wine, coins, etc.)
- Gift of partial interest in an asset
In addition, taxpayers owning businesses with outstanding PPP loans need to be careful if considering gifting interests in the business. See your tax advisor for additional guidance.
2. Sell a low tax basis asset and gift the cash. Biden has suggested repealing the current law that allows estate assets to be stepped up to the fair market value as of the date of death, resulting in a new tax basis. If this provision were to pass, the idea of selling a low basis asset and then gifting the cash might be more appealing for certain high net worth individuals. A parent might be better off paying the capital gains tax on the sale of an asset and then giving the full cash proceeds to the child rather than giving the child an asset with a low tax basis. Anytime a parent pays the income tax on assets that have been gifted or will be gifted, the payment of the income tax is basically a tax-free gift because it is not treated as a gift. Also, the payment of income tax by the parent removes that cash from their estate, which automatically saves estate tax at a 40% or potentially 45% tax rate.
Assume a parent owns stock in a company and has a zero-tax basis in the asset. If the parent gifts $10 million of the stock to the child (outright or in trust), the parent will use $10 million of their lifetime exemption, however, the child will have an asset with unrealized capital gains that could be taxed as high as 39.6%, if sold in the future. The net gift would be worth $6,040,000, after tax. However, if the parent sold the stock before the end of 2020 and gifted cash to the child, the parent will use $10 million of their lifetime exemption and pay income tax equal to $2.4 million (20% capital gains rate plus the net investment income tax of 3.8% = 24%). The child ends up with an asset with no unrealized capital gains and the parent removed an additional $2.4 million from their estate, which also saves estate taxes. Having the parent pay the capital gains tax on an asset to be gifted is basically a tax-free gift equal to the income tax paid. This decision should be discussed with an estate attorney, CPA and investment advisor.
3. Make a gift to a trust and still have access to the asset. If you are hesitant to gift property out of your estate because you think you might need access to those assets in the future, fear no more! There are various types of trusts where the person who creates the trust can be a potential beneficiary. For example, there are trusts that spouses can create for each other that will remove assets from the estate but allow the spouses to benefit from the assets in the future, if needed.
What if you make the gift and then the laws do not change next year? Can you change your mind about the gift next year? Typically you cannot, however, one of the nation’s leading estate planners, Jonathan G. Blattmachr, has advised that certain language can be added to the trust document that will allow a beneficiary to “disclaim” their interest in the trust so that it reverts back to the grantor/donor. This provision could allow you to unwind the gift in the event you change your mind.
A qualified disclaimer must be executed within nine months of the original transfer, so assuming the trust document includes the proper disclaimer language, you will have nine months from the date of the gift to decide if you want to unwind it. Requirements for disclaimers differ depending on state law, so consult a good estate tax attorney if you are considering adding this language to a trust.
4. Use up one spouse’s exemption and keep the other. If you are married and you are certain that you only want to make a $10 million gift or less, consider having one spouse use their lifetime exemption and the other spouse use zero of theirs.
For example, say that a husband and wife decide to gift $10 million to a trust for their children in 2020. If they split the gift, then the husband will use $5 million of his exemption and the wife will use $5 million of her exemption. In 2026 (or possibly sooner), when the lifetime exemption is reduced to an estimated $6 million per person (or even less than $6 million), the husband will have used $5 million of his exemption, leaving $1 million, and the wife will have used $5 million of her exemption, leaving $1 million. If the husband had made the gift alone and used $10 million of his exemption, in 2026 he would have zero exemption remaining, while the wife would have the full $6 million remaining. This would allow the couple to shield another $4 million of assets from the estate tax even after the law changes.
5. Ultra-high net worth individuals can do more. If you have taken our advice in #1 above and used up all the current lifetime exemption, there are additional estate planning techniques to consider in this environment where interest rates are historically low, and valuations may also be low:
- Grantor retained annuity trust
- Sale to an intentionally defective grantor trust
- Charitable lead trust
- Refinancing old family loans
- Sales of remainder interests
- Annual exclusion gifting
- Paying tuition and medical expenses directly to the institution for loved ones
- Late allocation of unused generation-skipping transfer tax exemption to old trusts
Stay tuned and reach out to our experts with any questions.
Pam brings to Armanino over 29 years of expertise in the estate, gift and trust tax area. Pam’s clients have been primarily high net worth multi-generational families, closely held business owners, executives, fiduciaries (corporate and individual), family offices, and beneficiaries of large estates/trusts. Prior to joining Armanino, Pam was a national resource for Deloitte as a subject matter expert in the areas related to estate tax, gift tax, post-mortem tax planning, fiduciary income tax and generation-skipping transfer tax and was an advisor to corporate trustees. Pam also spent 7 years with Goldman Sachs Private Wealth Management as a Senior Wealth Strategist covering Southern California, Texas and Las Vegas providing comprehensive planning to some of the wealthiest clients at Goldman Sachs focusing on tax planning related to estate, gift, generation-skipping transfer tax, income tax, charitable giving, family office services, transactional tax planning, stock option planning, and post-mortem tax issues.