In anticipation of President Biden’s proposed increase in the capital gains tax rate, taxpayers are deciding whether to accelerate earnings and how to defer them after an increase for as long as possible.
Uncertainty about the timing and extent of the increase, as well as other important details that will need to be established during the legislative process, makes short-term decisions challenging for taxpayers who could reach the threshold for the highest proposed rate.
But if the rate goes up, deferral strategies will be more valuable according to the size of the increase.
On April 28, Biden released the American Families Plan, which included a proposal to increase the capital gains rate for households with incomes above $ 1 million at the 39.6% rate for ordinary income. The plan also proposed eliminating the increase in the basis at death for earnings in excess of $ 1 million, or $ 2.5 million per couple when combined with existing real estate exemptions.
The announcement of the plan formally kicked off legislative discussions and prompted taxpayers to consider what options they might have now and in the future.
Increasing the capital gains tax rate to an effective rate of 43.4% (the proposed rate of 39.6% plus the net investment income tax of 3.8%) would put much more pressure on recognition events, said Steven M. Rosenthal of the Urban-Brookings Center for Fiscal Policy.
Even for taxpayers who might eventually be subject to a higher rate, it might be premature to sell investments now. “The sure way to deal with an increase in capital gains is to sell and get the profit now before the rate goes up, but what if the rate doesn’t go up?” said Ian Weinstock of Kostelanetz & Fink LLP.
For American taxpayers, that could be an expensive proposition. For non-US resident taxpayers, Sell and Buy Back is a much easier option, because they are subject to capital gains tax only on real estate investments.
Taxpayers can have time on their side to decide when to respond to a potential rate increase. It could be a matter of waiting to see how the legislation is finalized in Congress. “My hope is that as the process evolves, we will have more information about the direction it is heading,” Weinstock said.
Publishing the proposed American Family Plan was a step forward, but there will likely still be a long time before the resulting legislation becomes law.
Impact on opportunity zones
McDermott Will & Emery’s Steven Hadjilogiou said that some taxpayers are considering how to accelerate capital gains before a possible rate hike, but that under the Opportunity Zone regime, that is difficult to do.
He said it is possible to accelerate deferred gain while keeping the benefit of the 10-year holding period, although not all acceleration methods work.
Hadjilogiou said that investments in qualified opportunity funds will remain valuable even if the rate increase becomes law, but that the deferral will become a cost.
“I think investors in the short term are going to look at that potential rate hike and say no to investing in a QOF for that,” he added.
Congress and the Biden administration could modify the Opportunity Zone rules to allow the applicable tax rate to be the one that applied in the year the capital gain was realized, rather than the one that applies when the gain is realized. recognized on December 31, 2026.
Section 1400Z-2 does not specify what rate is applied, but the Treasury clarified in the regulations that the rate is the one in effect in the year in which the gain is recognized.
Hadjilogiou noted that this is consistent with other deferral regimes, such as installment sale rules and even the rules for 401 (k) plans, which apply the rate in effect in the year of profit recognition.
Business owners who typically don’t end up above the income threshold each year could face a nasty tax bill when they decide to sell their business or when they die.
Thomas J. Nichols of Meissner Tierney Fisher & Nichols SC said that profit making could be draconian for closed companies. For example, for some of those businesses, the only point at which the owner-operator would reach the proposed threshold of $ 1 million would be when they sell the business they have been building for years.
Spreading the profit from the sale of a business over multiple years under installment sale rules to avoid exceeding the threshold in any one year might be an option for some closed business owners, but might not be ideal.
The selling point for owners is usually to withdraw the money completely and not have to worry about keeping the business going.
“The decision to sell or not a business has so many implications that taxes cannot be allowed to fully drive the bus,” Nichols said. But the difference between a 20% rate for a taxpayer who is materially involved in your business and a potential rate of 43.4% is significant. “If that’s their nest egg, it’s really huge,” Nichols said.
The death of a closed business owner is often a difficult transition time for the business, and increasing the tax burden at that time could compound the problems it already faces, Nichols said.
“The loss of that person who held everything together never fails to have a substantial impact in terms of business continuity,” he said.
Allowing the tax increase to be paid over several years could mitigate the immediate impact, but could still present a significant challenge, because a closed business may not return to the same level of profitability after the death of the primary owner, Nichols added.
Taxpayers with closed businesses will likely explore options such as donations to charities or transfers to children for life to avoid activating some of the profits if the capital gains tax rate increases as proposed.
“These are very personal decisions and depend on many factors that have nothing to do with taxes,” Nichols said. “The combined burden of taxes on income and wealth could reach 60% under these proposals, and that could be devastating for a family business that is passed on to the next generation.”
Avoiding the threshold
There is no definition of income in the American Family Plan, but that will change if the proposal becomes law. Wherever the definition goes, taxpayers whose income is just above the threshold are likely to try to fall just below it.
In a post about the Urban-Brookings Tax Policy Center Blog, Robert McClelland explained that in 2018, about 40% of high-income households reported between $ 1 million and $ 1.5 million. By spreading income over time when possible, taxpayers could avoid the income threshold.
It may not always be an option, but it could become a more important planning tool in the event of a large rate increase.
Prior to a possible capital gains tax rate increase, taxpayers may decide to activate the earnings they plan to make soon anyway to be taxed at the current rate, rather than the potentially higher rate later. .
Hadjilogiou said that not only QOF investors, but also those who use installment sales have options to accelerate their earnings.
Similar exchanges were reduced to only real estate in the Tax Cuts and Jobs Act, limiting that route as an option to avoid profit recognition. Rosenthal said that taxpayers can start looking for investments that do not eliminate current income, such as growth stocks that do not pay dividends.
Risk management techniques, in addition to selling appreciated property, could become more attractive in an environment with higher tax rates on capital gains, he said.
The constructive selling rules under section 1259 apply to relatively few categories at this time, but as taxpayers seek put options, variable prepaid forward contracts, and other planning tools to defer profit, Congress may consider toughen those rules, he said. That could be a delicate balance, because under current rules, taxpayers must pay taxes if a derivative mimics the opposite of the position they occupy, but rules that go far beyond that could discourage legitimate coverage.
The scope of the proposed rate increase could also prompt taxpayers to rebalance their portfolios before the higher rates take effect.
“Normally, the tax incentives are so small that taxpayers wouldn’t bother, but it might deserve a little attention here because the increase is so large,” Rosenthal said.
Exchange-traded funds may become more attractive to investors looking to avoid capital gains tax because those funds often use in-kind refunds for some shareholders to avoid distributing dividends to all shareholders, Rosenthal said.
Section 852 allows funds to avoid recognizing the gain on the distribution of appreciated assets in kind as a redemption of shares. As the tax rate increases, the temporary benefit of that rule becomes more attractive because it provides a way to defer taxes.
The American Families Plan is just the initial offering in what will invariably be a longer process of implementing a capital gains tax rate increase.
As that process unfolds, the effects on tax planning will be focused.