Scary Tax Proposals Arrive Just in Time for Halloween

By: Andrew J. Willms

Members of Congress are proposing major changes to the tax code which, if passed, might play a very bad trick on your estate plan and your investment returns.

The U.S. government has undertaken a variety of measures in an effort to prevent a COVID-19 triggered recession (or worse).  For the most part, those measures have proven to be quite successful. However, these measures also came at a considerable cost.

Congress has spent an estimated $5 trillion in response to the COVID-19 pandemic, while the Federal Reserve is injecting trillions more into the economy in an effort to limit the pandemic’s ill-effects on the economy.

Next up is the co-called “Build Back Better Act” (“BBBA”), which if enacted would result in an additional $3.5 trillion in federal spending to expand government funding for education, health care and childcare support, the fight against global warming, and infrastructure improvements.  Because this legislation does not have enough support to withstand a Republican-led filibuster, Democrats are hoping to adopt it by a budget reconciliation measure, which only requires a simple majority vote[i].

But there’s a catch. Legislation adopted via reconciliation must pay for itself within the period set by the resolution (usually ten years), meaning Congress will need to raise taxes to pay for it.  And based on what’s been proposed so far, it seems much of the revenue that’s needed will be coming from raising taxes on gifts, inheritances, investment gains and those earning high incomes.

The following is a brief summary of some of the provisions contained in the House Ways and Means Committee’s plan to pay for the Build Back Better Act. 

Estate Planning Could Become More Taxing.

• Under the House Bill, a reduction in the estate and gift tax exemptions currently scheduled to occur on December 31, 2025 would be moved up to December 31, 2021.  As a result, next year the amount that can be given away during life or at death tax free would be reduced from $11.7 million to an estimated $6.02 million.

• Provisions currently included in the tax code permit estate planning with “grantor trusts” (which in simplest terms are trusts where the person who sets up the trust -- the “grantor” -- continues to be taxed on the trust’s income). The Bill would subject the assets of such a trust to estate taxation when the grantor dies, and treat distributions to persons other than the grantor or the grantor’s spouse, as taxable gifts.[ii]

• Minority interests in companies, partnerships and LLCs would be assigned a greater value for gift and estate tax purposes, if the assets of the entity are not used in the active conduct of a trade or business.  More specifically, value adjustments to account for a minority interest’s lack of voting control or lack of marketability would no longer be permitted.

If there is a silver lining, it might be that the House does not propose any of the following hot button changes that had previously been discussed: (i) elimination of the step-up in basis at death rules; (ii) “mark-to-market” taxation of unrealized appreciation at death; or (iii) increase of the 40% estate, gift, and generation skipping transfer tax rate.  Of course, this doesn’t mean that these potential changes can’t still make an appearance in future versions of the legislation.

Uncle Sam Could Receive a Larger Share of Your Investment Returns.

• The House Bill would raise the top marginal rate on long-term capital gains and qualified dividends to 25%.  The proposed effective date is September 13, 2021. (Earlier proposals from the President and the Senate would raise this rate to as high as 39.6%.)

• Under the House proposal, the taxes paid on long-term capital gains could reach as high as 31.8%, after taking into account the existing 3.8% tax on net investment income and the 3% surtax the House is proposing on high income earners (discussed below).

• It is worth noting that under earlier proposals by the President and Senate, the combined capital gain tax rate would top out at a whopping 43.4%.

The Wealthy May Have to Pay More

• Effective after December 31, 2021, the top marginal income tax rate would be increased from 37% to 39.6%.  The proposed effective date is taxable years beginning after December 31, 2021.

• In addition, as mentioned above, a 3% surtax would also be imposed on individuals with modified adjusted gross income in excess of $5 million (or in the case of estates and trusts, income greater than $100,000). 

• The House Bill proposes elimination of Roth conversions for single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of household with taxable income over $425,000 (all indexed for inflation). This provision would apply to distributions, transfers, and contributions made in taxable years beginning after December 31, 2021.

Although the House Bill includes numerous additional tax hikes in addition to those mentioned above, some legislative experts believe it does not raise sufficient revenue to cover the BBBA’s $3.5 trillion tab. If that proves to be correct, for the legislation to be adopted either taxes would have to be raised further, or the Act would have to be scaled back.

Although the House Bill proposes certain provisions (such as the capital gains rate hike) take effect sooner, at this point it seems that most, if not all, of the tax law changes will take effect after the end of the year. Given that, here are some steps to consider taking before the end of the year.

• If you haven’t used all of your current estate and gift tax exclusion amount, consider doing so by the end of the year (the sooner the better).  There are a number of relatively painless ways this can be done under the current tax code.

• Ask one of the estate planning attorneys at O’Leary-Guth Law Offices, S.C. whether a grantor trust and/or valuation discounts could allow you to transfer more of your wealth to your family tax-free. Planning techniques that may be lost as of the start of next year include Grantor-Retained Annuity Trusts, Spousal Lifetime Access Trusts, Intentionally Defective Grantor Trusts, and Irrevocable Life Insurance Trusts, to name a few.  Time is of the essence for this type of planning.

• Consider converting traditional retirement accounts to Roth accounts. 

• Consider harvesting tax capital gains by selling securities you own with unrealized gains before year end.  If changes in capital gain taxes are not retroactive, paying some taxes now could mean paying considerably less taxes later.

• Be more tax aware when investing in stocks and bonds.

For example, consider investing in low cost, tax-friendly exchange-traded funds (ETFs) rather than mutual funds and individual stocks and bonds.

Be wary of investment strategies that involve frequent trading, which can trigger greater taxes, higher expenses, and for the most part have a low probability of generating higher returns.   Tax sensitive alternatives include low turn-over rules - based investment strategies such as those used by The Milwaukee Company.

With the end of the year fast approaching, there is no time to wait. The time to act is now. As the old saw goes, nothing is more expensive than a missed opportunity.

Andrew Willms is the president and CEO of The Milwaukee Company, a wealth Management firm with over $1 billion in assets under management.

[i] 51 votes in the Senate, or 50 if the vice president breaks a tie.

[ii] These new rules are proposed to apply to grantor trusts created on or after the date of enactment and to contributions made to any grantor trusts on or after the date of enactment

[iii] It is possible that certain transactions may need to be completed earlier than December 31, 2021.