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Family offices and tax changes: Considerations from the House proposal

Tax increases would encourage wealthy families to act

INSIGHT ARTICLE  | 

Family offices anticipating a variety of tax law changes now have more details to consider. The House Ways and Means Committee on Sept. 13 outlined its proposal of various income and transfer tax increases on high-income individuals, estates and trusts as part of a plan to generate the revenue necessary to support reconciliation bill spending.

While the proposal does raise revenue through creating new taxes and curtailing tax benefits, absent from the proposal were many potential changes President Biden proposed that would affect family offices. The omissions highlight the challenges Democratic leadership faces in pushing through the reconciliation bill, especially as the Senate formulates its priorities.

Key elements of the House proposal are summarized below along with potential planning strategies to consider. It is crucial to note, however, these proposed tax law changes might not become part of the final bill or might change during the legislative cycle over the next few weeks or months.

Increase in top income tax rate (effective for years beginning after Dec. 31, 2021)

The top marginal tax rate for individuals, estates and trusts would increase from the current 37% to 39.6%. For individuals, the income level at which the top rate takes effect is reduced to $450,000 for married individuals filing jointly and $400,000 for single taxpayers. For estates and trusts, the level is unchanged at $13,450.

RSM insight:

As a result of the proposed increase, it may be favorable to accelerate income into 2021 or delay deductions into 2022 and beyond due to the rate increase. For those families that intend to make large charitable gifts in 2021, consider deferring the gift until 2022 when the deduction can be taken in a higher income tax year, but remember when making these considerations that the ability to deduct cash donations to certain public charities of up to 100% of income before deductions does not currently exist in 2022.

The rate increases could also make Roth conversions especially enticing in 2021 before the increased rates take effect. Also, if a taxpayer reached age 72 during 2021 and is now required to take his or her first required minimum distribution (RMD), it may be beneficial to take it in the current year instead of delaying it until 2022 as is permitted for first year RMDs.

Any time you defer deductions or accelerate income, keep in mind the opportunity cost of this sort of tax planning. You may be accelerating spending, so the investment returns on these expenses need to be considered.

Increase in top capital gains tax rate and limitation of the small business gain exclusion (1202) (effective for transactions after Sept. 13, 2021)

The proposal increases the top long-term capital gains tax rate from the current 20% to 25% for those individuals in the new 39.6% ordinary income bracket. There is no change to the unrecaptured section 1250 gain rate (25% gain on real estate depreciation) or the collectible gain rate (28%).

The proposed effective date for the increased capital gains tax rate would be for transactions after Sept. 13, 2021. The proposal also lays out a transition rule for 2021 requiring a separate accounting for gains and losses incurred before, on or after the Sept.13, 2021, effective date. The determination of when to account for pass-through gains and losses will be made at the entity level. In addition, the proposal includes a safe harbor provision for written binding contracts made on or before Sept. 13, 2021.

Qualified small business stock (1202 exclusion) (more on definition and exclusion) will only receive a 50% gain exclusion for high-income individuals with adjusted gross income (AGI) of $400,000 or more. Estates and trusts will only receive a 50% gain exclusion with no income threshold. This removes the 75% and 100% exclusion rules currently available. This is effective for sales or exchanges on or after Sept. 13, 2021, with an exception for written binding contracts in place prior to this date.

RSM insight:

Some families may want to take advantage of the of the broader 15% and 20% capital gains brackets in 2021 by accelerating any planned sales. In 2021, a married couple filing jointly does not reach the top capital gains rate until they have $501,600 (married filing jointly) of taxable income. Under the proposal, beginning in 2022, the threshold at which long-term capital gains are subject to the highest rate is $450,000 (married filing jointly).

Next, we will cover the proposed increase in the net investment income tax and the new high-income surtax. Both are effective for tax years beginning after Dec. 31, 2021, so there is an opportunity to save up to 6.8% of the gain on the sale of a business where you materially participate (3% for passive assets) by accelerating a 2022 transaction into 2021. The effective date of the capital gains rate increase could also move to a later date after legislative negotiations, which could result in additional tax savings if the sale occurs before a revised effective date.

Net investment income tax (3.8%) (effective for years beginning after Dec. 31, 2021)

The proposal would expand the reach of the net investment income (NII) tax to include trade or business income for high-income individuals. The general result would be that all income above a threshold amount would be subject to self-employment tax (SECA), employment tax (FICA) or net investment income tax except for growth in a qualified retirement plan.

NII tax would be imposed on the greater of “specified income” or “net investment income” for taxpayers above the high-income threshold. The term “specified income” includes income from a trade or business not subject to payroll taxes regardless of a taxpayer’s activity level. The high-income threshold is $500,000 for married individuals filing jointly and $400,000 for single filers. There is a gradual phase-in for income levels between $500,000 and $600,000 (married filing jointly). The proposed expansion of the NII tax base most notably captures income from S corporations, limited partnership interests and some LLC interests that are currently not subject to self-employment taxes.

RSM insight:

The expanded definition of NII to include active trade or business income could have a material impact for many business owners. The NII tax is in addition to regular income taxes, so families should consider both tax increases in determining whether to accelerate income or delay deductions. You could also consider maximizing contributions to qualified retirement plans to further reduce income.

This may also be a suitable time to reconsider your choice of business entity type. Depending upon the way you operate your business, converting to a C corporation may be a logical decision.

Limitations on excess business losses (effective for years beginning after Dec. 31, 2020)

The proposed tax bill would make permanent the excess business loss limitation that under current law was set to expire in 2026. The limitation under the current law caps losses from a trade or business at $500,000 for a married couple but allows them to be treated as net operating losses (NOLs) in future years. Under this proposal, disallowed excess business losses would no longer receive NOL carryforward treatment and would instead continue to be subject to the excess business loss limitations in subsequent tax years. This change would require sufficient business income in future years to be able to deduct disallowed losses.

RSM insight:

Due to its retroactive nature, there are limited opportunities to avoid the impact of this provision. Planning that would increase business income may also protect families from excess business loss limitations. Also, for some taxpayers this may mean a reevaluation of 2021 estimated taxes will be required should this become law.

Surcharge on high-income individuals, estates and trusts (effective for years beginning after Dec. 31, 2021)

The proposal imposes an additional 3% tax on AGI (as modified for the investment interest expense deduction) above $5 million ($2.5 million for married filing separately). Of note, estates and trusts only have an income threshold of $100,000 before the surtax applies. The additional 3% tax will not apply to trusts where all interests are devoted to, among others, a religious, charitable or educational purpose.

RSM insight:

The threshold imposed on estates and trusts is significantly lower than the threshold for individual taxpayers. This lower threshold will make normal income distributions and distributions made under the 65-day rule more critical in future years.

This new tax would not be effective until years beginning after Dec. 31, 2021. This provides an opportunity to increase income during 2021 to avoid the new tax. For individuals in future tax years, the plan could be to limit taxable income to dollar amounts below $5 million through limiting controllable income items.

Estate and gift tax exemption reduced (effective for decedents dying or gifts made after Dec. 31, 2021)

The temporary increase in the estate tax exclusion enacted under the Tax Cuts and Jobs Act (TCJA) is set to expire in 2026. This provision would result in a reduction of the exemption, returning it to the previous level as indexed for inflation. The estimated exemption amount for 2022 would be $6,020,000.

RSM insight:

Some families may want to consider using their remaining exemptions by making completed gifts or transfers to trusts before the year’s end to take advantage of the current, much higher, estate and gift tax exemption amount of $11.7 million. There may be limitations to the type of planning strategies available considering the proposed changes to grantor trusts and valuations that are addressed below.

The early bird gets the worm. There are a limited number of qualified professionals able to effectuate this sort of planning; therefore, waiting may put you in a position where you are unable to plan. Some taxpayers are planning to create the necessary trusts now and then fund them closer to enactment date, so they have more time to perfect the transaction.

Estate tax inclusion of grantor trusts and gain recognition on sales to grantor trusts (effective on the date of enactment)

A grantor trust would be includible in the grantor’s gross estate if the taxpayer is a deemed owner for income tax purposes. In addition, sales or exchanges between a grantor and a grantor trust would no longer be disregarded for income tax purposes. This change would be effective for trusts created on or after the date of enactment, and contributions after enactment for trusts that were created prior to the law. Grantor trusts created and funded before enactment would be unaffected.

This provision has potentially far-reaching consequences that will affect the future of grantor-retained annuity trusts (GRATs), irrevocable life insurance trusts (ILITs), spousal lifetime access trusts (SLATs), intentionally defective grantor trusts (IDGTs), grantor charitable lead annuity trusts (CLATs) and other planning strategies.

RSM insight:

The far-reaching impacts of this provision on GRATs, ILITs, SLATs, IDGTs, and CLATs and other planning techniques is concerning. Families currently considering transactions or making annual contributions involving grantor trusts should be aware of the limited period in which they may have to complete those transactions without adverse estate consequences. A simple gift to an ILIT could result in partial estate inclusion for the grantor under these rules.

The wording of these provisions is peculiar, referring to a “contribution” to a trust. The use of this word is not common in reference to transactions involving trusts. This leaves open the possibility of including transactions with grantor trusts not commonly thought of as contributions, such as sales, asset swaps, and refinances of old debt or installment obligations. The effect could be inclusion of a portion or all the trust assets in your estate. Planning around these rules may require relinquishing certain powers to “turn off” the grantor status of a trust or considering certain trusts “off limits” for future “contributions.”

Before the date of enactment, you may want to consider gifts, sales, swapping assets, extending or accelerating existing installment sale obligations, or extending loan terms.

Valuation rules for certain transfers of nonbusiness assets (effective on the date of enactment)

Under the proposal, valuation discounts would be disallowed for nonbusiness assets held by an entity. Nonbusiness assets are passive assets held for the production of income but not actively used in the trade or business. These types of assets would include, but are not limited to, cash, stock or securities; an equity, profit or capital interest; real property; personal property; and various other types of investment assets This definition excludes reasonably required working capital used in the trade or business.

There is also a look-through provision that applies if an entity holds at least a 10% interest in another entity. The entity would be required to “look-through” to the assets held by the underlying entity and be deemed to own a direct proportional share of the assets in making a valuation determination.

RSM insight:

This bill would dramatically decrease those assets that are eligible for a valuation discount. For example, only a select group of people termed “real estate professionals” would be eligible for discounts on rental real estate assets. Transactions involving valuations of entities that hold nonbusiness assets should be completed before the date of enactment to take advantage of discounts still temporarily available.

Limit on qualified business income deduction (effective for years beginning after Dec. 31, 2021)

The deduction for qualified business income (QBI) under 199A will be capped at specified amounts: $500,000 for married filing jointly, $250,000 for married filing separately, $10,000 for estates and trusts and $400,000 for all other taxpayers. The current phase-outs of the deduction would remain the same.

RSM insight:

Families should consider accelerating income or delaying deductions when possible if this will affect their eligibility for the QBI deduction. QBI is also still available on section 1245 depreciation recapture if the transaction is completed by year-end.

Takeaways

These proposed changes would have a material impact on the tax burden for high-income individuals and wealthy families, as well as the estate and trust planning that has been previously done.

Surprisingly, the proposal had no mention of other anticipated changes, including:

  • No change to step-up in basis at death, the imposition of capital gains at death or any changes to the generation-skipping transfer tax
  • No relief from the $10,000 cap on state and local tax deduction
  • Carried interest tax break made more restrictive, but not eliminated

Again, those omissions underscore the difficulty that Democrat leadership faces in advancing many of the proposals sought by the Biden administration.

While the Ways and Means Committee approved the current draft, largely along party lines, there are still several steps that will shape the final legislation.

The current bill will be sent to the Budget Committee, which packages this, and other House committee reconciliation bills, into a single bill that is reported to the House floor. Limitations on debate and offering amendments while reconciliation measures are being considered are typically set by the House Rules Committee.

A similar process unfolds in the Senate, where the relevant committees, such as the Senate Finance Committee if the measure involves taxes, will draft its own version of the reconciliation bill and submit it to the Budget Committee for further action. Senate rules under reconciliation require that amendments be germane and limit the time allowed for debate. Any differences emerging between the House and Senate bills must be resolved through a conference report, which will require approval again from both the House and Senate to the modified measure.

This process will take time and certainly make headlines as it progresses. RSM will be monitoring this situation closely, including continually communicating with our contacts on Capitol Hill. As the legislative cycle plays out over the next few weeks and months, stay updated with our insights at our tax policy resource center and subscribe to our tax alerts and publications.


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