The House Ways and Means Committee released proposed changes to the tax law on September 13, 2021. Although it is far from certain when or which of these proposed changes will be enacted into law, given the potential far-reaching impact of the proposals it is prudent to begin to think about actions that might be appropriate if they were to be enacted. The following proposals are anticipated to become effective as of January 1, 2022, unless otherwise noted. This summary focuses on the ten changes most likely to affect Fiduciary Trust clients.
Income Tax Provisions
1. Capital Gains: Long-term capital gain and qualified dividend income rates would increase from a maximum of 20% to 25%. This proposed rate is significantly less than President Biden’s proposal of a maximum at the top ordinary tax rate. Under this new proposal, the 25% rate would be effective for gains recognized after September 13, 2021. In addition, the 3.8% net investment income tax would apply.
- Section 1202 deductions for high-income taxpayers would be limited to a 50% exclusion instead of the 75% or 100% exclusion now potentially available.
- Carried interests would require a 5-year holding period, instead of 3 years, in order to avoid ordinary income tax rates.
Action: Delay recognizing capital losses until 2022. Despite this increase, you may still want to consider accelerating gains into 2021 in light of the next few proposed changes.
2. Income Surcharge: A new 3% surcharge would apply to individuals with modified adjusted gross income (MAGI) over $5,000,000 ($2,500,000 for married filing separately (MFS)) and to irrevocable trusts and estates with MAGI over $100,000. This tax would be equal to 3% of amounts that exceed the MAGI limits with deductions for investment interest expense allowed in calculating MAGI.
Action: Consider accelerating income and gains into 2021, especially for irrevocable trusts.
3. Net Investment Income Tax (NIIT): The application of NIIT would be expanded to not only apply to an individual’s interest, dividend, and capital gain income, but to also include pass-through net investment income from the ordinary course of a trade or business including income from the sale of other property beyond financial assets. This broader application would capture pass-through income from an S corporation or partnership, and would apply to MAGI of $500,000 for married filing jointly (MFJ), $400,000 for head of household (HOH) and single individuals, and $12,500 for estates and trusts. Income subject to FICA tax is not subject to NIIT.
Action: Consider accelerating income to 2021. Revisit pass-through structures to confirm if changes are desired.
4. Ordinary Income Tax Rates: The top ordinary income tax rate would increase from 37% to 39.6% (before NIIT and surcharge). This would apply to ordinary income over $450,000 for MFJ, $225,000 for MFS, $425,000 for HOH, $400,000 for single individuals, and $12,500 for trusts and estates.
Action: Consider accelerating income into 2021 and/or delaying charitable gift bunching to 2022.
5. Qualified Business Income Deduction: Under current law, through 2025 taxpayers can deduct 20% of qualified business income flowing from a partnership or S corporation, as well as certain other entities. The proposed legislation would set a maximum limit on deduction to $500,000 for MFJ, $250,000 for MFS, $400,000 for HOH and single, and $10,000 for trusts and estates.
Wealth Transfer Provisions
6. Gift and Estate Tax Exemption: The current $11,700,000 gift and estate tax exemption is comprised of the exemption amount plus an equal amount that is a temporary increase or bonus exemption. Under the proposal, the bonus portion of the exemption would sunset on December 31, 2021, instead of on December 31, 2025, leading to an exemption amount in 2022 around the $6,030,000 range after indexing for inflation.
Action: Consult with your estate and financial planning advisors as you consider funding trusts with your current remaining gift/estate tax exemption before December 31, 2021, if you have sufficient resources available to do so. This particularly applies to irrevocable life insurance trusts (ILITs), grantor retained annuity trusts (GRATs) and spousal lifetime access trusts (SLATs).
7. Grantor Trusts: Grantor Trust status currently allows a grantor to enjoy income tax-free transactions with their irrevocable trust as well as pay any income taxes related to the trust’s income from their personal assets without such payment being considered a gift. This allows the assets inside the grantor trust to appreciate more quickly since the trust does not bear the burden of income tax payments, all of which can be done without additional estate or gift tax consequences. Under the proposed changes:
- Sales or exchanges between a grantor and his/her trust would be an income taxable event,
- Distributions from the trust to beneficiaries other than the grantor’s spouse would be deemed gifts,
- Trusts with grantor trust status would be fully includible in the grantor’s estate, and
- The act of terminating grantor trust status during the grantor’s lifetime would be considered a gift.
These changes would apply to grantor trusts established after the date of enactment of the proposed legislation and to any amounts transferred to an otherwise grandfathered grantor trust after the date of enactment. These provisions would not apply to revocable trusts or to trusts that are fully funded before the date of enactment.
Action: Consult with your estate planning and financial advisors as you consider fully funding ILITs and other grantor trusts, such as GRATs and SLATs, prior to the date of enactment. Also, consider whether terminating grantor trust status now is a preferred course of action or if any modifications to existing trusts are desirable before date of enactment.
Retirement Asset Provisions
8. Mega IRAs:
- Contributions Limited: An individual with $10,000,000 or more in his/her combined tax-qualified defined contribution plans, including IRAs, at the previous year end with an adjusted taxable income (ATI) above $450,000 for MFJ, $425,000 for HOH, and $400,000 for MFS and other individuals, will not be allowed to make additional contributions to IRAs or Roth IRAs. The income amounts and cap would be indexed for inflation beginning in 2023.
- Required Distributions: Regardless of age, distributions will be required if an individual’s total retirement plan assets (including inherited IRAs) exceed $10,000,000 at the end of the previous calendar year and the individual has an ATI at the levels noted in the previous bullet. If a person’s total retirement plan assets exceed $20,000,000, the required distributions are even more significant. Retirement plan assets over $10,000,000 but under $20,000,000 are subject to a 50% required distribution with the individual selecting the accounts to source the distributions. In addition, amounts over $20,000,000 are subject to a 100% required distribution to bring the total back to $20,000,000. Roth IRA or Roth designated accounts must be used first, to the extent they exist, to satisfy the 100% distribution amount for accounts over $20,000,000. Withholdings for non-Roth distributions are mandated at 35%. Those under 59½ would not be subject to the 10% penalty for early withdrawals for any distributions required due to mega account balances.
Action: If you have Roth retirement assets and your total retirement assets are expected to be in excess of $20,000,000 at the end of this year, and your 2022 income is expected to be above the levels noted, take a distribution from your non-Roth retirement assets before December 31, 2021, to bring the total down below $20,000,000 in order to preserve the benefit of the Roth assets you have. If you are not over age 59½, this action in 2021 would include a 10% penalty tax for early withdrawals.
Furthermore, if your retirement assets are expected to be above $10,000,000, you should consider taking distributions in 2021 to lock in the lower ordinary income tax rate for what next year would be a required distribution.
9. Back-Door Roth Conversion, Roth Rollovers and Conversions: Currently an individual who is not eligible to directly fund a Roth IRA can make an after-tax contribution to a traditional IRA or, in some cases, make an after-tax contribution to a retirement plan, and then soon thereafter convert those amounts to a Roth IRA without income tax consequence. Making after-tax deposits into an IRA or plan and then almost immediately moving the funds to a Roth IRA is a Back-Door Roth Conversion. Going forward, assets that are not already in a Roth account could only be rolled into a Roth account if doing so would cause the full amount to be included in taxable income at the time of conversion. In addition, beginning in 2032 (yes, 2032), taxpayers with AGIs above the thresholds noted in this Retirement Plan Provisions section would not be allowed to perform Roth conversions.
Action: Consider maximizing Roth conversions during 2021 to take advantage of the lower maximum ordinary income tax rate structure.
If you customarily utilize a Back-Door Roth Conversion and have not done so for the 2021 tax year, take that step before December 31, 2021.
Learn More: Roth Conversions: Is Now the Time?
10. IRA Investment Restrictions:
- Private Placement Securities: Beginning in 2022, IRAs will not be allowed to invest in private placement securities, such as those requiring representations that the owner has a minimum level of income or assets. If an IRA holds such a security at the date of enactment, the IRA must distribute or divest the holding by the end of 2023. Violating these investment restrictions will result in the IRA losing its status as an IRA as of the beginning of the tax year, and as with other prohibited transactions, this is a violation that cannot be cured.
- Substantial Interests: IRAs will no longer be allowed to invest in companies that are not publicly traded on a securities market if the IRA owner has a substantial interest, defined as more than 10% of the combined voting power, capital or profits interest, or beneficial interest. This is a decrease from the current 50% threshold. In addition, the IRA owner cannot be an officer or director of any company in which the IRA invests. Similar to the Private Placement rules above, beginning in 2022 no new investments of these types can be made, and all existing investments violating the rules must be distributed or divested before 2024.
Action: Do not make investments in IRAs that require accredited investor status or in which you have a substantial interest. If your IRA holds such an investment, begin to explore how to comply with the proposed restrictions in a timely manner. Be aware of other prohibited transaction and self-dealing rules to avoid inadvertently engaging in such transactions during the divestment process.
It is uncertain whether the provisions outlined by the House Ways and Means Committee proposals will be enacted, and if they are exactly what form they will take. One item conspicuously absent from the proposals is the revocation of the long-standing step-up in tax basis received when assets are included in a person’s estate. It is possible that changes to the step-up in basis rules, as well as other provisions, could be included in final legislation as negotiations continue.
If you have any questions, about how these proposals would affect you or what steps you should consider now given your situation, please reach out to your tax or planning advisor. Your Fiduciary Trust Officer is also available to discuss these proposals with you.
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The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.