Highlights of the “American Families Plan” Tax Proposal

On September 13, 2021, the House Ways and Means Committee released draft legislation that includes proposals covering a range of tax increases along with substantial increases in spending. As proposed, the $3.5 trillion American Families Plan will be the largest expansion of spending since the New Deal. If enacted, it will finance a range of social programs such as universal pre-kindergarten, extended childcare, and expansion of the coverage provided under the Affordable Care Act (Obamacare). It also contains meaningful changes to the tax code that will result in higher taxes for both individuals and corporations.

As you might imagine, at over 800 pages, the House proposal covers a broad range of initiatives (including the proposed tax changes). Before the bill can be enacted, it must go to the House floor, the Senate Finance Committee and through reconciliation. Senators Kyrsten Sinema of Arizona and Joe Manchin of West Virginia are both positioning to exercise influence on the eventual shape of the tax legislation as both represent necessary Senate votes to pass any legislation. Both have expressed concerns about the scale of the legislation along with concerns about aspects of the proposed tax provisions on both the individual and/or corporate tax side. As a result, further changes to the House proposal are virtually certain.

While changes to the proposed legislation are expected, we now have a somewhat clearer picture of the likely areas of tax law that will undergo change. The legislation as proposed incorporates many of the original features of the Biden tax plan – most relevant to this summary, increases to the income and capital gains tax rates for high income taxpayers. Still, there were many changes made to the Biden plan that limit the tax impacts that would have otherwise been included.

It should be noted that some of the proposed changes to current tax policy reflect an acceleration of the sunset provisions that were built into the Tax Cuts and Jobs Act of 2017 (TCJA). In other words, given the TCJA sunset provisions, some of the currently proposed tax changes would become effective in 2026 even if no new tax legislation is enacted.

This summary will focus on those provisions most relevant to individual taxpayers. Given the scope of the legislation, this summary does not address all the proposed changes that could affect you, your family or your business.

Back to the Future

One of the key elements of the tax plan involves the reinstatement of the 39.6% maximum income tax rate. The 39.6% rate had been the top rate from 2013 through 2017. It was reduced to 37% following the enactment of the 2017 Tax Cuts and Jobs Act. While the increase in the maximum tax rate is likely to garner most of the press, of equal, and perhaps greater consequence is the income level at which the maximum rate becomes effective. As you can see from the table below, the maximum tax rate kicks in at a significantly lower level of income when compared to the current tax brackets. The change in rates also shrinks the 35% tax bracket relative to what is in place currently.

(Source: https://www.kitces.com/blog/biden-american-families-plan-bill-proposed-increase-tax-capital-gains-retirement-reform/)

New Long-Term Capital Gains Tax Rate (effective 9/14/2021

As can be seen in the following table, another provision of the proposed tax legislation is a new, higher 25% long-term capital gains tax rate for higher income taxpayers. While the proposed change to the ordinary income tax rates would become effective in 2022, the proposed change to the top long-term capital gains rate would become effective for long-term gains realized on or after September 14, 2021.

(Source: https://www.kitces.com/blog/biden-american-families-plan-bill-proposed-increase-tax-capital-gains-retirement-reform/)

The tax proposal does contain a limited exception to the 25% maximum capital gains tax rate. This involves a property (or business) sale where a binding, written sales contract exists prior to the September 14 effective date. This exception would only apply to qualified sales that close before the end of 2021.

Where a property or business sale satisfies the exception requirements, the gain will be treated as having occurred prior to September 14, 2021 and therefore would only be subject to the current 20% long-term capital gains rate.

While the higher 25% tax rate seems likely to be enacted, there is at least some chance that the September 14 effective date may change. The longer it takes for the eventual legislation to pass, the less certain it is that the September 14 date will hold.

New 3% Surtax for Ultra High-Income Taxpayers

Under the House proposal, those taxpayers with incomes above $5 million, will now be subject to an additional 3% surtax on their “modified adjusted gross income” that exceeds $5 million. The same $5 million threshold will apply to both single and joint filers.

With such a high income threshold, few taxpayers are likely to be subject to the surtax. However, taxpayers do need to be aware that a significant event like a property or business sale could push the taxpayer’s income over the $5 million threshold and thus be subject to the surtax.

While the surtax income threshold for individual taxpayers would be set at $5 million, the income threshold for trusts would be set at $100,000. Since trust income will include interest, dividends and realized capital gains, it is likely that many more trusts will be subject to the surtax than individual taxpayers.

Expanded Child Tax Credit Extended and Enhanced

Earlier this year, President Biden signed the American Rescue Plan, which included a significant expansion of the Child Tax Credit. This increased the credit amount from $2,000 to $3,000 and up to $3,600 for children under the age of 6 (while making the credit a fully refundable tax credit). The proposed legislation extends the expanded credit through 2025 while liberalizing the definition of a qualifying child and beginning in 2023, formally transitioning the credit into a monthly credit payable to families throughout the year.

Roth IRA Changes

As proposed, the legislation will ban “Backdoor Roth IRA Contributions”. This is a strategy where individuals whose income is above the Roth contribution limits make a non-deductible contribution to a standard IRA and then roll it over to a Roth (an immediate conversion of regular IRA to Roth IRA).

We’ve liked to employ the “backdoor” strategy for clients where it has been possible to do so. Unfortunately, this strategy has become a concern to the IRS which considers the technique a tax-avoidance scheme. If enacted, the legislation will ban the use of this strategy regardless of income level.

The proposed legislation also contains a provision that would prohibit Roth conversions of after-tax dollars held in retirement accounts (both IRAs and employer-sponsored retirement plans). This restriction would become effective in 2022. If enacted (which seems likely), individuals with after-tax contributions, particularly IRA owners, will need to decide whether to convert these funds into a Roth this year. Beginning in 2022, the conversation option for after-tax dollars will go away and only conversions of pre-tax contribution dollars will be allowed.

In a very odd choice of effective date, effective January 1, 2032, Roth conversions will be eliminated for taxpayers with incomes of $400,000 for single filers and $450,000 for joint filers. This timing can be seen as a generous “allowance” to give these taxpayers a 10-year runway for such conversions (and create additional tax revenue for the IRS attributable to conversions over this period).

Provisions Relating to Traditional IRAs

The legislation contains additional provisions relating to regular IRAs as well. In this case, these provisions apply to high income taxpayers ($400,000 for single filers, $450,000 for joint filers) with total retirement account balances of $10 million or more. For those taxpayers who meet both the income and account balance thresholds, the legislation establishes new accelerated requirements for “required minimum distributions” (RMDs). These taxpayers will also be prohibited from making any additional IRA contributions.  Interestingly, this restriction does not apply to contributions that may be made to an employer sponsored retirement plan or to SEP or SIMPLE IRA accounts.

Provisions for Business Owners

Currently, profit distributions from sub-chapter S corporations are not subject to employment taxes (the “FICA” or self-employment tax) or the Net Investment Income Tax (NIIT). This dual exemption allows S corporation owners receiving these distributions to avoid taxes regular W2 wage earners must pay.

If enacted, the legislation would change the treatment of these profit distributions for certain high-income owners of S corporations. There is quite a bit more to the definition and calculation of qualifying income however, high-income owners would see a 3.8% surtax applied to profit distributions where the taxpayer’s income exceeds $400,000 for Single filers or $500,000 for Joint filers.

This change, in conjunction with the proposed increase in the highest income tax rate, could result in owners of S corporations seeing a maximum federal income tax rate of 43.4% (39.6% + 3.8% = 43.4%).

The proposed legislation also addresses a special provision of the current tax code. Section 199A of the current code allows many S corporation small business owners to claim 20% of business income as a deduction. The proposed legislation phases out this benefit for those with incomes of $400,000 for individual filers or $500,000 for joint filers.

While these proposals can certainly change during the reconciliation process, it seems highly likely that high-income owners of S corporation are likely to see an increased tax bite.

Estate Tax Changes

The big estate-related news associated with the proposed legislation is the significant reduction in the estate and gift tax exemption amount that would be available to individuals. Following the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), the exemption amount for individual taxpayers was increased from $5 million to $10 million (indexed for inflation). Today, the combined estate and gift tax exemption for individuals has risen to $11.7 million ($23.4 million for married couples). This has effectively eliminated the estate tax for all but a tiny fraction of citizens.

Under the proposed legislation, the current exemption amount for individuals would be reduced to $5 million (indexed for inflation). Current estimates are that the exemption amount effective in 2022 would be approximately $5.7 to $6 million after inflation adjustments.

This change accelerates one of the sunset provisions of the TCJA that would otherwise occur in 2026. While this reduced exemption amount will still be substantial, the change will mean that many more families may be subject to an estate tax. Accordingly, those who may be subject to a future estate tax will want to consider whether gifting some portion of their estate while the higher exemption amounts are still in force is desirable. If so, acting quickly will be essential – and planning that involves establishing family trusts will need to be completed prior to the enactment of this legislation.

Trusts subject to higher tax rates

Trusts reach the maximum income tax rate, currently 37%, after only $12,500 in taxable income (versus $400,000 of income for individual taxpayers). This rate will now rise to 39.6%. Also, as previously noted, trusts will also be subject to the 3% surtax on only $100,000 of trust income. This threshold is particularly significant where a trust may be the beneficiary of a retirement account and receiving annual distributions that push trust income above this level.

Changes to the Tax Code Relating to Trusts

For the wealthy, a fundamental estate planning strategy often involves the transfer of assets to one’s children and heirs during one’s lifetime. By using the lifetime gift exemption (currently $11.7 million per individual) the objective is to reduce one’s taxable estate while transferring both assets and the expected growth to a future generation. This is most often accomplished by establishing an irrevocable trust to hold and manage these assets for the trust’s beneficiaries.

A key understanding with respect to this trust planning is that irrevocable trusts, which transfer assets outside one’s estate, are separate entitles for tax purposes. As noted above, trusts are subject to income tax rules that are more onerous than those for individual taxpayers – for example, reaching the maximum tax rate at only $12,500 of income.

Over the years, the tax code has evolved, and trust strategies have come into being that allow for trust income to be taxed to the original grantor (i.e. treated as a grantor trust) while still treating the trust assets as being outside the grantor’s estate (a relationship that conveys some unique benefits).

One of the more common trust strategies established under these rules is known as an “Intentionally Defective Grantor Trust” (IDGT). The IDGT is not the only trust type that would be affected by the proposed legislation relating to grantor trusts but it does represent a useful illustration of the type of trust strategy that will no longer be allowed. There are other trusts, for example, certain “Irrevocable Life Insurance Trusts,” that could be similarly affected by the proposed changes to the grantor trust rules.

Under the proposed legislation, if a trust is to be treated as a grantor trust for income tax purposes, that trust and all its assets would still be included in the grantor’s estate. This defeats the fundamental objective of removing the assets from the grantor’s estate. Accordingly, these “defective” grantor trusts will no longer be viable estate planning techniques.

There are number of provisions in the legislation affecting grantor trusts and estate planning strategies involving these trusts. What is most important to know is that as proposed, the legislative changes related to trusts will become effective upon enactment (when the legislation is signed).

It is expected that any trusts existing at the time of enactment will be grandfathered and only actions taken after enactment would be subject to the new provisions.  Trusts created after the date of enactment would be subject to the new, less-favorable grantor trust treatment. Accordingly, those who may wish to employ more complex estate planning strategies involving grantor trusts will need to act quickly to ensure such actions are completed before any legislation is passed.

Estate Planning – Changes to Family Limited Partnership Discount Valuations

At present, the value of interests in a Family Limited Partnership (FLP) are typically discounted based on assumed limitations on the control and marketability of the FLP interest and its underlying assets. When the asset in question is an operating business, this makes sense. When the FLP assets are easily marketed, liquid securities, the rationale for discounts associated with these assets is more questionable.

The proposed legislation would add new provisions to the Internal Revenue Code regarding the valuation of assets for gift and estate tax purposes. The new provisions would stipulate that when a private business interest is transferred (such as a Family Limited Partnership), there will be no discount available for any “nonbusiness” assets held in the business entity (although the remaining business assets would still be eligible for a discount). In other words, the value of cash or any marketable securities held in a FLP would not be eligible for discount treatment. This potentially increases the amount of lifetime exemption needed to be used to transfer assets into a FLP.

As you might imagine, there is much more to the language and definitions associated with this change but for practical purposes, the key takeaway is that the use of discounts for future gifts to FLPs is likely to be significantly curtailed (and discounts associated with liquid securities eliminated). Accordingly, if the use of discounted gifts to a FLP is a part of your current estate transfer strategy, acting before the proposed legislation is enacted will be essential.

What’s Next

The scope of the proposed legislation is substantial, and it is virtually certain to change as it moves through Congress. Although the final provisions remain uncertain, it is likely that changes to many areas of the tax code affecting individuals, trusts and business will be enacted. Most of these provisions will become effective in 2022 but those relating to estate planning may become effective upon enactment (and the capital gains rate change could have an even earlier September 14th effective date).

Given the timing involved in negotiating and finalizing any legislation, there is still time to take action in advance of enactment. But time is of the essence – particularly in those areas relating to the use of the current $11.7 million lifetime exemption limit or other areas of estate planning strategy. The key is to consult with your professional team right away. Estate planning attorneys, in particular, are likely to be in high demand before any legislation becomes effective.

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