What could the proposed tax changes mean for your estate plan?
The American Families Plan would include income tax increases for high-income taxpayers but doesn’t make changes to the estate tax. However, several congressional proposals target transfer taxes and could still be incorporated into a tax reform bill.
One of the tax increases proposed by President Biden during his campaign was a reduction in the estate tax exemption, taxing amounts transferred to heirs in excess of $3,500,000 per person as opposed to the current exemption of $11,700,000. However, instead of making changes to the estate tax exemption, the American Families Plan would be paid for primarily with an increase to the top income tax rate, from 37 to 39.6%, as well as by eliminating the preferential rate for capital gains and dividends for households making over $1 million.
In addition, the American Families Plan would eliminate the “step-up” in cost basis at death that’s allowed under current law. This basis adjustment eliminates any unrealized capital gains when the owner of an asset passes away, allowing heirs to sell the asset without recognizing any taxable income. Biden proposes to eliminate this adjustment for gains in excess of $1 million ($2.5 million per couple) and appears to require that unrealized gains are realized in a deemed sale upon death, causing capital gains taxes to be due. The proposal does, however, mention exceptions for family-owned businesses and farms. Several key details of this proposal are uncertain until legislative text is provided, but the stated exceptions are expected to be significant.
The concept of death as a gain realization event would be new to the U.S. tax code but has been proposed separately by both House and Senate Democrats in recent months. On March 29, 2021, a full month before the Biden administration released its proposal, House Ways and Means Committee Member Bill Pascrell, Jr. (D-New Jersey) introduced H.R. 2286, and on the same day, Senator Chris Van Hollen (D-Maryland) issued a discussion draft of a bill titled, “Sensible Taxation and Equity Promotion Act of 2021,” or the STEP Act. Both proposals would require not only that gain be recognized in a deemed sale at death, but upon gift transfers during life as well, with exceptions for transfers to spouses or charities. In addition, both would require a periodic deemed sale event for assets held in irrevocable trusts (every 30 years under H.R. 2286 and every 21 years under the STEP Act).
One notable difference between the two proposals is the effective date. H.R. 2286 would apply to gifts and transfers made after Dec. 31, 2021, while the STEP Act would be effective Dec. 31, 2020, meaning it would apply retroactively to transfers made in 2021. While the prospect of retroactive tax legislation seems unlikely, particularly as we move into the latter half of the year, it’s still possible and should be taken into consideration for any planning undertaken in 2021.
The likelihood of significant changes to basis adjustments and deemed sale provisions is up for debate. The basis adjustment allowed at death has long been viewed by many as more of an administrative convenience than a tax break for the wealthy, as it can be very difficult to ascertain the cost basis of an asset held for many decades. Therefore, allowing a “reset” of basis upon one’s passing alleviates the need for such cumbersome recordkeeping. However, the fact that the concept has support from the Biden administration, as well as from numerous members of Congress, indicates that the idea is gaining traction.
Many estate plans are structured to take advantage of the basis adjustment at death and may need to be revisited if that adjustment is eliminated. Some estates may also face a liquidity issue that must be planned for, since a deemed sale would cause tax to be due without an actual liquidation event. Estates with illiquid assets, such as the family business, may need to find the cash to pay the tax due if not covered by an exception. Furthermore, if new legislation were to treat lifetime gift transfers as deemed sales as well, additional consideration will need to be given to which assets are the most appropriate to transfer.
While the more recent focus has been on changes to capital gains taxes and basis adjustments, there have already been several proposals targeting the estate and gift tax system, most notably Bernie Sanders’ “For the 99.5% Act,” introduced on March 25, 2021. This bill would make sweeping changes to estate and gift taxes, including an increase in the tax rates, a decrease in the allowable exemptions, and provisions targeting many of the strategies currently utilized to reduce estate and gift taxes. While this proposal as a whole may be too robust to garner sufficient support for passage, it’s entirely possible that parts of the bill could make their way into a different tax reform package. In contrast to the other current proposals, the Sanders bill already exists in the form of statutory language, which means that it would be easy for legislators to incorporate one or more of the provisions into another piece of legislation. This is common practice when a revenue raiser is needed to pay for other spending provisions in a bill.
It’s impossible to predict whether any of these proposals will be enacted in their current form. While the Democrats do control both the House and the Senate, assuming no Republican senators would vote in favor of any of the proposals, they would need the support of every single Democratic senator to pass legislation in the Senate with the simple majority required by the budget reconciliation process. Regardless of the exact changes that are likely to be made, it’s clear that Democratic members of Congress and President Biden are focused on tax reform, which could mean higher taxes for many. It’s also important to note that, even without legislative action, the current elevated estate tax exemption of $11,700,000 per person is scheduled to sunset on Dec. 31, 2025, at which point, it’ll be reduced by half. This means that the window of opportunity to take advantage of current favorable tax laws could be closing.
Individuals who may be affected by these potential changes should reach out to their advisors to discuss their estate plan and ensure that they are prepared for any change in law. As suggested by the proposals, the still-elevated gift and estate tax exemption, and commonly used effective wealth transfer techniques, may be impacted considerably by future tax legislation.