Qualified opportunity zones are communities that have been designated by the government as needing greater infrastructure investment. Investors in these zones can defer certain gains (or, for a limited time, reduce gains).

Lawmakers have curbed taxpayers’ ability to engage in tax-deferred like-kind exchanges in recent years, and the administration has indicated a desire to curtail that activity even more. But it is still possible to reinvest the proceeds from the sale of investment-related real estate into replacement properties while deferring at least some of the tax.

Roth Accounts Become More Important
Roth IRAs and Roth 401(k) accounts already offer substantial tax benefits to those willing to contribute after-tax dollars (with no federal income taxes on future growth generated by the investments). But in a world with much higher capital gains rates, the Roth calculus would become even more compelling for high earners. First, the available tax savings would be greater. Better still, by minimizing future income, a high earner is more likely to be able to stay under the $1 million adjusted gross income threshold.

Which Entity?
Business owners already have a tough choice when deciding how best to organize their businesses for tax purposes. Should they be structured as a sole proprietorship, a C corporation, an S corporation, a limited liability company, a partnership or some other form of business entity?

If long-term capital gains were taxed at ordinary income levels for high earners, this decision would become even more complex. C corporations, for example, could become more popular because, in some cases, their stock can be treated as qualified small business stock (as we discussed earlier).

Then again, if the corporate income tax rate went up too, C corporations would face increased double taxation. Pass-through entities might also become less popular, since the 20% qualified business income deduction is scheduled to expire after 2025.

Also, consider the implications of the net-investment-income tax of 3.8%. High-income taxpayers fear that if the Biden administration gets its way, the new maximum capital gains tax rate for them would be 43.4% (39.6% + 3.8%). That’s true in many cases, but not all the time. The net-investment-income tax allows exemptions for certain pass-through entities when the owners and entity are actively engaged in a trade or business. This simple distinction would itself become much more important in a higher-rate environment.

Complex Business Sales
Business sales would also become more complex. Yes, the taxes for a sale could be higher, but the structuring of the deal would require even greater planning, often long before any sale. Business owners would try to avoid higher taxes, taking advantage of available tax mitigation strategies and possibly proactive pre-sale gifting (depending on how gifts are treated under the new law). Even the strategic use of installment sales would need to be reconsidered, depending on how the final capital gains rules are implemented. For example, could a business owner sell in a low-income year and use the installment method to make sure the entire sale is taxed at a lower rate?

Philanthropic Planning Becomes More Important
It’s critical that people with philanthropy in mind take advantage of charitable contribution deductions, but it would become even more critical that they donate highly appreciated long-term assets without ever having to recognize the built-in gain—assuming the new law does not limit this opportunity (which is possible). This long-used strategy could become even more common amid substantially higher capital gains tax rates. So unless the laws addressing charitable deductions change, expect to see a proliferation of donor-advised funds and similar structures in a new tax regime.

Charitable trusts also would become more popular. These allow donors to contribute appreciated assets into a charitable trust in exchange for a deduction and a continuing, tax-efficient income stream, a strategy that could become even more valuable in the context of higher taxes.

Gifting Becomes More Routine
It’s harder to predict what will happen with gifts, since the administration has floated the idea of recognizing capital gains on gifts to non-spouses (within limits). If that doesn’t ultimately happen (and the carryover-basis regime survives), gifting would still be a good way to defer taxation (at least until the recipient sells the assets). Of course, gift taxes must also be considered, but gifting would still be a useful technique to blunt and defer taxes if rates rise. If the government does decide to recognize gains on gifts, then the opposite may be true, though it seems likely there would be exceptions to allow for at least some gifting of appreciated assets.

A Greater Need For Planning
So this is what financial planning could look like in an environment of tax increases. It would, in any event, look quite different and far more complicated than the world we live in now, and there would be a far greater emphasis on planning designed to ensure that well-advised, high-income taxpayers never feel the full brunt of the increases.

Michael J. Nathanson, JD, LLM, is chairman and chief executive officer of The Colony Group.

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