William R. Stromsem, CPA, J.D and Assistant Professor, George Washington University School of Business
The direction of federal tax legislation and policy for the next two years may depend on the outcome of the Georgia runoff election for its two U.S. senators on Jan. 5. If the Republicans win either of those seats, they will retain control of the Senate and likely prevent the unwinding of provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) and the raising of the tax rates on higher-income individuals and businesses as have been proposed by President-elect Joe Biden.
If the Democrats win both seats, the Senate will have an equal number of Democratic and Republican senators, with Vice President-elect Kamala Harris having power to cast the tie-breaking vote to give Democrats a majority in the Senate. This would mean that if Democrats vote along party lines, they would:
- Be able to pass any legislation requiring a simple majority,
- Take over the Senate leadership,
- Take over Senate committees (including the tax-writing Senate Finance Committee), and
- Have a larger staff to support their work.
Taking over both chambers of Congress might also be seen as a mandate by Democrats for their tax legislative agenda.
Reflecting the fundamental importance of the Georgia runoff, it is likely to be the most expensive in U.S. history, with both parties initially planning to spend at least $200 million in the state. It is impossible to call the election with so much advertising and get-out-the-vote organization, so for year-end tax planning we should be prepared for possible changes. Also, from a political perspective, most of Biden’s proposals affect high-income taxpayers who constitute a very small portion of voters in relation to those with lower incomes who may want to reduce the disparity in wealth and to have higher-income individuals and businesses pay more to support government programs and reduce the deficit.
If the Republicans win either of the Georgia Senate seats, tax planning will be similar to planning in the past—generally accelerate deductions and defer income. Although their path is a narrow path, if the Democrats win both Georgia seats, then there are a number of possible tax law changes that could require prompt action by taxpayers and these will be covered in the rest of this article.
Higher Tax Rates on High-Income Individuals
Biden has said that he will not raise tax rates on those with income of $400,000 or less, but that for taxpayers with incomes above that amount, marginal tax rates would increase from 37 to 39.6%. A 2.6% increase in income taxes does not sound like much, but that is not the end of it—there are other proposals that might increase effective tax rates for high-income individuals. Increased rates would probably apply from Jan. 1 and would be a blended rate for the full year, rather than having one rate for income before the legislative change and another for after the change.
Unfortunately, we will not know the results of the Georgia runoff until Jan. 5, after the current tax year ends. However, high-income individuals who can take bonuses or accelerate compensation might consider doing it before year end. Pass-throughs and sole proprietorships might want to accelerate income into 2020. Those with regular IRAs may want to consider converting them to Roth IRAs while the rates are lower. Note that this is the opposite of traditional year-end planning that emphasizes deferring income.
Social Security Tax Changes
Biden’s proposal would collect Social Security taxes on earnings over $400,000 for an additional 6.2% for an employee, adding to the 39.6% marginal rate in high-income earners for a total rate of 45.8%. For self-employed individuals and businesses with owner-employees, both the employer and employee parts of Social Security would have to be paid, adding another 6.2% and bringing the effective marginal tax rate to 52% on earnings.
This is an interesting proposal in that it would retain the current cap on Social Security earnings at $137,700 ($142,800 next year) but would then start collecting Social Security taxes again for those with earnings over $400,000. Benefits’ calculations would likely continue to be capped at the current level with no additional benefits from the additional taxes paid.
Capital Gains Tax Rates
Biden has said that for individuals with incomes over $1 million, he would eliminate the preferential tax rate, currently at 20%. This would mean that for those high-income taxpayers, long-term capital gains would be taxed at 39.6%, plus the net investment income tax of 3.8%, for a total of 43.4% versus 23.8% total currently. Individuals with long-term gains in their portfolios might consider selling before the new rate applies. This may not require action by year end because the new rate would likely be structured to have separate rates on gains before and after a tax bill is introduced (or first considered by the House Ways and Means Committee or some effective date other than a retroactive application to Jan. 1). This effective date is speculative, but it could give taxpayers a chance to see the results of the Jan. 5 Georgia runoff before rushing to sell and ending deferral of tax on their unrecognized gains. Going forward, the incentive to invest for capital gains would be reduced by roughly 20% of the gain and might encourage some changes in investments.
The Biden plan would eliminate the preferential tax rate on qualified dividends, raising the tax rate from 20 to 39.6% for high-income individuals. This might cause rethinking of investment selections overall, with dividend stocks yielding roughly 20% less than currently.
Biden has expressed a desire to restore the Pease limitation (cap on itemized deductions repealed by TCJA) for those with incomes over $400,000. A high-income taxpayer may wish to accelerate charitable contributions and other itemized deductions into 2020 rather than possibly losing them to Pease limits in 2021.
If the Democrats control the Senate and House, there will be a push to restore the full deductibility of state and local income taxes, which were capped at $10,000 in the TCJA. This could be a benefit to those with higher income and high-value real estate in states where high tax rates apply. Congressional leaders such as Senate Minority Leader Chuck Schumer and House Speaker Nancy Pelosi from New York and California have urged restoring full deductibility of state taxes and would likely add this to any major proposed tax legislation. This is not a sure thing, however, with some not wanting to skew benefits to high-income and wealthy individuals in other states. Also, if the Pease limit is enacted, this might limit the availability of the deduction for higher-income individuals.
Note that the strategy for accelerating or deferring deductions depends on the taxpayer’s circumstances; e.g., defer paying state and local taxes hoping to be able to deduct them next year, but accelerating other deductions into 2020 to avoid Pease limitations in 2021.
Qualified Business Income Deduction for Pass-Through Entities
The qualified business income deduction (QBID) was created by the TCJA to give pass-through business owners a tax break somewhat commensurate with the corporate tax rate reduction from 35 to 21%.
However, Biden proposes that the QBID be phased out for those earning more than $400,000 a year. This would mean that the marginal tax rate for income from pass-through entities for high-income individuals would increase from an effective rate of 29.6% (the 37% top rate less the tax-free 20% QBID) to the maximum individual income tax rate of 39.6% with no QBID. This marginal rate can go up to 52% for high-income earners who own pass-throughs as described in Social Security tax changes above.
Biden’s proposal would increase the corporate tax rate from 21 to 28% and would also eliminate the preferential rate for qualified dividends, and this may create disparities in rates between corporations and pass-throughs that could affect future choice of business entity decisions.
High-income individuals with QBID may wish to accelerate business income into 2020 to maximize the QBID rather than possibly losing it altogether in 2021.
Step-Up of Basis at Death
Biden would eliminate the tax-free step up in basis at death. Without this step-up, taxpayers may wish to consider selling appreciated investments by year end to take the gains at current rates rather than at the new higher rates for themselves or their heirs. If inherited assets have a built-in loss, the basis will likely not carry over, with the heir’s basis being fair market value at date of death, similar to treatment of depreciated gifts.
Although the president-elect may recommend carryover basis, this may be difficult to enact with several prior unsuccessful efforts, even having been enacted in the Tax Reform Act of 1976 and then repealed retroactively because of difficulties in determining the basis of a decedent who is not around to explain any possible adjustments.
Estate and Gift Taxes
Biden and Sen. Bernie Sanders worked with experts to develop Democratic Party policy recommendations that included addressing wealth redistribution. The policy position states that, “Estate taxes should also be raised back to the historical norm.” This has since been specified to set the unified credit offset amount to $3.5 million per taxpayer, roughly one third of the current amount. In addition, the offset for lifetime gifts would be limited to $1 million per taxpayer. Biden would also increase the top estate tax rate to 45 from 40%. Some high-net-worth families might wish to make wealth transfers by taxable gifts while they can still use the unified credit to offset larger transfers. This proposal may be difficult to enact with a narrow majority in the Senate and with some senators voting across party lines to protect family businesses and farms in their states.
Wealth Taxes and Even Higher Rates?
During the Democratic primaries, Sanders and Sen. Elizabeth Warren made strong cases for redistribution of wealth through wealth taxes on high-net-worth individuals and for higher income tax rates on high-income individuals. If the Democrats take the Senate, there may be pressure for more aggressive tax policies to address perceived disparities in wealth. Although Biden has not embraced wealth taxes, Democrats may perceive the turnover of Congress as a mandate and might send the president-elect bills that go beyond what he may want. The Biden-Sanders Unity Task Force on Building a More Progressive Tax System pledged to, “Use taxes as a tool to address extreme concentrations of income and wealth inequality. As a means of strengthening tax progressivity and paying for investments in U.S. productivity, increase taxes on the wealthiest Americans by limiting unequal and unproductive tax expenditures. In addition, limit the ability of wealthy taxpayers to defer and avoid taxes on income (especially that relate to financial investments) … and expand payroll taxes on upper-income taxpayers to fund more generous Social Security benefits.”
High-income individuals and their tax advisers should watch the results of the upcoming Georgia election and be prepared to act quickly if necessary to reduce taxes, including taking some actions defensively before year end. With high debt from coronavirus and economic recovery, with proposals to provide added benefits for health care and education, and with major infrastructure plans and other possibly expensive programs, revenue will need to come from somewhere, and the president-elect’s proposals are aimed at raising roughly $3.33 trillion in taxes over the next 10 years primarily from high-income individuals and businesses. Year-end tax planning could be extremely important this year for your high-income clients.