Of course, because I have worked with many of the same individuals and families for many years this informs my advice and the alternatives I present. I already know their risk quotient for different types of risks. This is one of the reasons why I believe that highly effective private wealth lawyers are ones that have a holistic understanding of their clients over a long period of time.
Shifting Political Winds
What does this all mean in the current political climate and what, based upon current polling, is likely to happen after the election in November. To give some context, federal tax legislation can become effective on January 3, 2021 when the newly installed 117th Congress officially convenes. Legislation may be introduced on that date and passed and signed into law later in the year and made retroactive to January 3, 2021 because there is no specific constitutional bar against retroactive tax legislation that increases a taxpayer’s tax liability.
Such legislation would likely be challenged in court on several grounds of course and in some cases retroactive taxes have been struck down based on due process concerns under the Fifth Amendment because of extended periods of retroactivity and a lack of notice of a new tax. Constitutional protections may also apply if the legislation appears to target certain taxpayers or it attempts to penalize past conduct.
Any retroactive tax legislation found to be a criminal penalty will also likely be struck down as a violation of the Ex-Post Facto Clause, and tax legislation that targets certain taxpayers might also raise concerns under the equal protection guarantees of the Fifth Amendment. These and other legal positions would take years to wind through the courts and many will be novel cases of first impression. In short, taxpayers fighting against potentially overreaching retroactive tax legislation would be fighting an uphill battle with the power of the U.S. Government against them.
What could this new tax legislation entail? Well, we already know what the presumptive Democratic nominee Joe Biden has proposed. Biden’s proposal would tax capital gains and dividends as ordinary income for taxpayers who report $1 million or more of such income, and tax capital gains at death. Currently capital gains and dividends are taxed at 20% plus a 3.8% net investment income tax or approximately 23.8%.
Biden would also raise the maximum tax rate from 37% to 39.6% so the tax rate on capital gains and dividends for these taxpayers will increase to 43.4% (39.6% plus 3.8%) before any state and local taxes. Currently built-in, untaxed gains go untaxed at death but are potentially subject to a 40% estate tax. Under this proposed change these gains would likewise be taxed at 43.4% at death plus a potential estate tax of 40% (presumably on the balance of the assets’ total value after payment of the income tax on the built-in gain).
The estate tax will also affect more taxpayers than is currently the case because Biden has already stated that he would repeal major provisions of the 2017 Tax Cuts and Jobs Act (TCJA) presumably including eliminating what is currently a $11.58 million per person and $23.16 per married couple estate tax exemption. The $11.58 million estate exemption for 2020 is currently scheduled to remain in place and may even increase slightly from year to year because it is regularly adjusted for inflation, but it is slated to expire after 2025.
If Congress were instead to repeal the estate tax exemption next year then the exemption would revert back to the pre-2018 level of $5.49 million ($10.98 million for married couples) or perhaps even lower if more aggressive tax pruning takes place beyond just repeal, thus subjecting many more assets and family wealth at death to both income tax at ordinary income rates on any untaxed gain and a 40% estate tax on the remaining value of the estate.
The Biden proposal would also increase the corporate tax rate to 28% from its current 21% and would phase out the special reduced flow-through tax rate of 29.6% on business income and instead tax this income at regular ordinary income tax rates of a maximum of 39.6% for taxpayers with income above $400,000 per year.
In addition to the increased maximum 39.6% income tax rate, taxpayers currently are and will continue to be subject to three additional taxes on their salary, wages, self-employed income, and other compensation income or so called “earned” income. These three additional taxes are social security taxes (currently at 12.4%), Medicare tax (currently 2.9%) and an additional Medicare tax (currently 0.9%). The self-employment tax rate is 15.3% of net earnings, the total of the 12.4% Social Security tax and the 2.9% Medicare tax on net earnings. The additional 0.9% additional Medicare tax also applies on net earnings from self-employment exceeding $200,000 for single filers or $250,000 for joint filers; however, for 2020, only the first $137,700 of earnings is subject to the Social Security tax of 12.4%.
Taxpayers who are not self-employed and who receive W-2 salary and wages split the Social Security and Medicare taxes (i.e., employee pays 7.65% and the employer pays 7.65%); self-employed people pay both halves for a total of 15.3%. Therefore, the short-hand way of describing the tax rate for high earners was always to say it was 40.8%, 37% maximum tax rate plus the two Medicare taxes totaling 3.8%.
Under the Biden proposal, this rate will increase to 55.8% before state and local taxes for taxpayers earning more than $400,000 per year because the maximum income tax rate will increase to 39.6% plus the Medicare taxes of 3.8% plus the Social Security tax of 12.4% will now also apply to these earnings over $400.000.