It is time to do yearend tax planning. We think that it is fair to say this yearend is unlike most other yearends, if not unlike any other yearend.
Several unusual factors affecting tax planning now exist.
• The COVID-19 crisis and its effect on many aspects of our lives, including our finances and our taxes.
• Historically low interest rates that are now prevalent.
• The basic exclusion amount for determining unified credit against Federal estate tax and gift tax at $11.58 million per taxpayer in 2020 and scheduled to be cut in half at the end of 2025.
• Unrecognized capital losses in many investment portfolios.
• The 2020 Presidential election and the candidates’ tax policies, where we will start our discussion.
2020 Presidential Election and Tax Policies
President Trump has not set forth significant new comprehensive tax proposals during the 2020 campaign. While there are many tax provisions in the 2020 COVID-19 relief laws, the 2017 Tax Cuts and Jobs Act (the “TCJA”) is the signature tax legislation of the Trump administration. Most individual tax changes in the TCJA are set to expire after 2025. Mr. Trump has proposed that most, if not all, of these individual tax changes be made permanent.
If elected, Former Vice President Biden is expected to try to end many of these TCJA tax changes early, possibly as soon as 2021. However, Mr. Biden may not act so soon. He certainly would be expected to weigh the effect of repealing TCJA tax cuts on our fragile COVID-19 economy.
Mr. Biden has not released a single formal tax plan, but he has proposed many tax changes. Most, but not all, involve tax increases on individuals with higher incomes, on estates (and their beneficiaries), and on businesses. Highlights of Mr. Biden’s tax proposals include:
For individual taxpayers (and estates) –
• An increase in the top tax bracket from 37% back to 39.6% (the top rate before the TCJA).
• An increase of the tax rate on long-term capital gains and dividends from 20% to 39.6% (the top ordinary income tax rate) on income above $1,000,000. The net investment income tax of 3.8% is added to these tax rates, where applicable.
• Eliminating the basis step-up (or step-down) at death for inherited property.
• Reducing the lifetime basic exclusion amount.
• Imposing the 12.4% social security tax (split evenly between the employer and employee) and self-employment tax on earnings over $400,000. Currently, social security taxes on earnings max out when income reaches $137,700. Note the “donut hole” for income between $137,700 and $400,000.
• Restoring the “Pease reduction” on itemized deductions for taxable income above $400,000.
• Capping the value of itemized deductions at 28 percent for those in higher marginal tax brackets.
• Expanding the child and dependent care credit to $8,000 per child (up to $16,000), and making it refundable and payable in advance
For businesses –
• An increase of the top corporate tax rate to 28% – up from 21% beginning in 2018 (still less than the 35% to rate in 2017 and previously).
• Creating a minimum tax on corporations with book profits of $100 million or higher.
• Phasing out Section 199A, which provides a 20% deduction for income from pass-through businesses, for those earning over $400,000.
• Increasing the 10.5% global intangible low tax income (“GILTI”) tax to 21%.
• Establishing or expanding several tax credits that encourage efficiency upgrades, process changes, and facility retoolings that benefit certain types of communities.
• Ending subsidies (tax incentives) for fossil fuels.
• On September 9, 2020, Mr. Biden proposed a 10% “Made in America” tax credit and a 10% tax penalty for U.S. companies offshoring manufacturing and service jobs and then selling back to the U.S. market.
Enactment of Mr. Biden’s tax plans hinges on the Democrats retaining control of the House of Representatives and gaining control of the Senate. Without this “sweep,” it is highly unlikely that, if he is elected, most of Mr. Biden’s tax plans would materialize as law.
We expect that there will be an overwhelming demand for estate and income tax planning services in late 2020, if Democrats sweep. As Matthew Crow, President of Mercer Capital, has written, “[t]his is a good time to think seriously about estate planning before tax planners become as scarce as toilet paper was in April.” Income tax planners will be swamped, too. It would seem prudent to at least invest in some tax pre-planning as soon as possible, unless you are absolutely certain that a Democratic Party sweep will not happen in November.
Selected Tax Planning Ideas
Following are eight tax planning moves to consider now. (There are quite a few more that could be beneficial. Consult your tax advisor.)
1. If you have a substantial net worth and can afford to use all of your remaining unified credit (combined gift and estate tax exemption)- – a total of $23.16 million for a married couple, less any exemption allocated to previous transfers – you should do so and do so soon. We recommend gifting, rather than dying.
This historically high unified credit enacted as part of the TCJA is scheduled to expire at the end of 2025 and be cut in half. Mr. Biden is understood to support a much lower unified credit. He may advocate much earlier revocation of the expanded unified credit.
2. Gift assets with the greatest likelihood of appreciation. Thus, future appreciation escapes estate taxes. Asset values temporarily depressed by the COVID-19 crisis may be particularly good choices for gifts.
3. Make intrafamily loans at historically low interest rates. In order to avoid imputed interest income to the intrafamily lender, the interest rate on a loan over $10,000 between family members should equal or exceed the Applicable Federal Rate (“AFR”) published monthly by the IRS. The AFR varies based on the term of the loan. Revenue Ruling 2020-20 prescribes the AFR for October 2020. (The AFR can change monthly.) The long-term AFR applies to loans of more than nine years. The AFR for long-term loans compounding at least annually and made in October is 1.12%. (The mid-term AFR is 0.38%. It is applicable to loans with maturities of more than three and up to nine years.) Thus, for example, a parent could make a 20-year loan at 1.12% to a child of a substantial sum that the child could invest in a securities portfolio. The income from and appreciation on the portfolio is not treated as a gift. A parent could also loan the child money to buy a house. (The actual rules are rather complex. Be sure to consult your tax advisor.)
4. Consider a grantor retained annuity trust (‘GRAT”). A GRAT freezes the value of assets in the hands of the grantor while transferring any appreciation to the beneficiary (usually the next generation). An individual creates a GRAT by transferring assets into an irrevocable trust for a fixed term, while retaining the right to receive an annuity stream factoring in a rate of return in an amount of at least the “Section 7520 rate” published monthly by the IRS. (The Section 7520 rate is the rate that is 120 percent of the AFR midterm rate (compounded annually) for the month in which the valuation date falls, with the rate being rounded to the nearest two-tenths of one percent). For October 2020, the Section 7520 rate is 0.4%. GRATs can be great, but they are tricky. Really tricky. You need to involve legal counsel skilled in estate planning with GRATs.
5. Tax loss harvesting – People may have unrecognized losses in their investment portfolios. Traditionally, while considering the “Wash Sale” rule restrictions, investors often harvest capital losses before yearend, if they have recognized capital gains during the year. (If possible, you should usually avoid offsetting tax-advantaged long-term capital gains with short-term capital losses.) This may still be a good strategy. However, consider the possible effect of Mr. Biden’s proposals. Might it not be best for a high income individual to recognize a long-term capital gain taxed at 20% (or 23.8%) in 2020 and use the capital losses against next year’s long-term capital gains that may be taxed at 39.6% (or 43.4%)?
6. Tax gain harvesting. Refer to item 5 immediately above.
7. Roth conversions. A Roth IRA is a powerful investment vehicle – no taxes on portfolio income or gains, no taxes on distributions, no required minimum distributions. (Note that, except in limited cases, a Roth IRA is subject to the 10-year distribution rule introduced in the 2019 SECURE Act.) If your income is lower in 2020 than in normal years, you might consider a taxable conversion of a traditional IRA to a Roth IRA. You may want to manage the amount of the conversion in order to keep the conversion taxed in your current lower income tax bracket.
8. Charitable contributions – The CARES Act allows certain charitable contributions in 2020 to be deductible up to 100% of adjusted gross income, compared to 60% or less in 2019. These “100%” contributions must be made in cash to public charities and not to donor-advised funds or support organizations.
There are many more tax planning considerations that may be appropriate. As noted above, some are complicated by 2020 being a Presidential election year. Contact your HM&M tax advisor to discuss your yearend tax planning.
Last updated 9/29/2020
For questions, please contact your HM&M advisor.
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