With Democrats needing to convince 10 Republicans to cross the aisle to enact a tax proposal in the Senate, President Biden’s tax proposals are most likely to move into, and take shape within, the budget reconciliation process where a simple majority of 51 votes are needed. In a practice not seen since 2016, on May 28, 2021, the Biden Administration reviewed and issued an accompaniment to the Administration’s Budget, referred to as the Green Book, that offers general explanations of the revenue proposals. The Green Book contained more detail, insight, and a couple of surprise changes to proposals in The American Jobs Plan and the American Families Plan, which President Biden released shortly after he signed into law the American Rescue Plan Act in March.
Below is a chart that highlights the proposed changes for individuals and corporations as well as some possible implications if these proposals are enacted into law. The proposed effective date for most of the changes is January 1, 2022, unless otherwise noted.
Highlights from Green Book
- Increased long-term capital gain and qualified dividends preferential tax rate to ordinary tax rate for taxpayers with adjusted gross income (AGI) over $1 million, retroactive to date of announcement in 2021, meaning either the budget transmittal date of May 28, 2021, or the date The American Families Plan was released on April 28, 2021. The increased rate for taxpayers with AGI over $1 million in 2021 beginning on the effective date through December 31, 2021, is 37% and 39.6% beginning January 1, 2022.
- Gift transfers of appreciated property are subject to gain realization. Donor would realize capital gain at time of gift.
- 15-year fixed rate payment plan available for tax on appreciated assets transferred at death, excluding liquid assets and businesses for which the estate tax deferral election was made.
- Proposed gain recognition on unrealized appreciation of property owned by a trust, partnership, or other noncorporate entity every 90 years. The first possible gain recognition event would be December 31, 2030, as the applicable period for this provision begins January 1, 1940.
- Clarification on the gain realization exception for family owned and operated businesses – Appreciation would not be taxed upon death or gift until the business is sold or the business ceases to be family owned and operated.
Tax Upon Death Due to Proposed End of Step-Up in Basis
It is worthwhile to highlight the proposed end of the step-up in basis at date of death for gains more than $1 million for individuals or $2 million for married couples, or $1.25 million and $2.5 million respectively if including the home gain exclusions. Below is a simple example illustrating the tax impact to a married couple upon death under The American Families Plan vs. current law.
Under current law, the taxpayers’ heirs would inherit the assets with a cost basis equal to the fair market value at the date of death of the taxpayers and there would be no taxation of the unrealized gains of $3.9 million. Under the proposed American Families Plan, the unrealized gains more than $2.5 million, in this case $1.4 million, are taxed upon death. Assuming a 40% tax rate, the estimated tax would be $560,000.
There is a proposed 15-year payment plan available for tax on the gain from appreciation of certain illiquid assets. In this example, the tax on the $400,000 taxable gain at death from the personal residence would qualify for the 15-year payment plan. The payment of tax on the $1,000,000 gain from the marketable securities cannot be deferred since it is a liquid asset.
Mergers & Acquisitions Considerations
In addition to the end of the step-up in basis, the proposed increase of the long-term capital gains tax rate for income earners over $1 million to 37% as of the date of announcement for 2021 and 39.6% as of January 1, 2022 could have a significant impact on the after-tax cash flow from a business sale.
In the below chart we summarize the potential cash flow impact from a $20 million sale. Assuming the current 20% long-term capital gains tax rate, a business owner could net approximately $16 million after tax from the sale of their business. Under the retroactive date of announcement proposed in the Green Book, that same business owner could net $12.6 million due to the proposed increase in the capital gains tax rate. If the sale were to occur in 2022 at a 39.6% long-term capital gain rate, that same business owner could net $12.08 million.
If business owners are contemplating a sale, because of the retroactivity proposed in the Green Book and the potential for a significantly larger tax bill because of such an impactful long-term capital gain rate increase, it has never been more important to consult with advisors on ways to strategically move forward with the sale.
The Tax Warriors are keeping a careful eye on Washington for news and clarification of the proposed tax law changes and will post updates as information is released. If you have questions about how the Biden tax proposals may impact your future income, gift, and estate tax liabilities, call on The Tax Warriors to discuss your situation.