Understanding potential tax law changes

May 3, 2022 | Market news

After legislation designed to drastically alter the tax code failed to pass Congress in 2021, new tax proposals have been presented to Congress by President Joe Biden’s administration as part of the administration’s proposed budget for Fiscal Year 2023. These potential changes are outlined by the U.S. Department of the Treasury in a document commonly referred to as “The Green Book.”

The revenue proposals reflected in the Green Book are before Congress for its consideration and approval during the course of the year. Additional tax legislation that may match or differ from some of the Green Book proposals is likely to be developed and reviewed as well by Congress in the months to come.

Although there is no clear timeline for when any legislation is expected, or even any certainty that new tax policies will gain Congressional approval, it’s important to be prepared for potential changes that could affect your tax liability. This is a summary of key relevant provisions of the administration’s tax proposal, as presented in the Green Book, that may impact you.

Who could be affected by these proposed changes?

The proposals included in the Green Book cover a wide range of tax laws, though the impact will be felt mostly by a narrow group of taxpayers. Nevertheless, the changes may be of concern to you if you meet any of these criteria:

  • Have adjusted gross income equal to or exceeding $400,000 for single tax filers, or $450,000 for those who are married and filing a joint return
  • Itemize deductions on your federal tax return
  • Have current or planned trusts
  • Are an owner of a limited partnership, limited liability corporation (LLC), “S” corporation or “C” Corporation

Note that the proposed effective dates of various changes to the law are not consistent. While most would take effect after December 31, 2022, some could become effective at an earlier date. Note the effective dates as you review the provisions below.

This is a summary of key relevant provisions of the administration’s tax proposal, as presented in the Green Book, that may impact you.

Tax rates for individuals

“Surcharges” on certain high-income taxpayers

Current law
The highest tax rate is 37%, which applies to income that exceeds:

  • $539,900 for individual tax filers (other than a surviving spouse)
  • $647,850 for married couples filing a joint return
  • $539,900 for heads of household
  • $323,925 for married couples filing a separate return

Proposed changes
The Green Book proposals would raise the top tax bracket to 39.6% from the current 37% level, and reduce the applicable income thresholds to:

  • $400,000 for individual tax filers (other than surviving spouses)
  • $450,000 for married couples filing a joint return
  • $425,000 for heads of household
  • $225,000 for married couples filing a separate return

Minimum tax

Current law
There is currently no minimum tax requirement that is applied to individuals.

Proposed changes
A new 20% tax rate on total income, generally inclusive of unrealized capital gains, would apply to taxpayers with total wealth (net of liabilities) exceeding $100 million. Provisions include the ability to pay a minimum tax liability in nine equal installments in the first year. In subsequent years, the minimum tax liability would be payable in five equal installments over the course of the year.

Payments of the minimum tax liability will be treated as a prepayment credit that can be applied towards subsequent capital gains realized in the future to avoid double taxation of capital gains. Because of various factors that go into the calculation of meeting the $100 million threshold, taxpayers should be aware that the minimum tax is fully phased in for taxpayers with wealth in excess of $200 million.

The proposal would be effective for taxable years beginning after December 1, 2022.

Tax changes that could affect investments

Tax rate on long-term capital gains and qualified dividends

Current law
The top tax rate is 20%. In 2022, it applies to long-term capital gains and qualified dividends generated if income exceeds:

  • $459,750 for individual tax filers (other than surviving spouses)
  • $517,200 for married couples filing a joint return
  • $488,500 for heads of household
  • $258,600 for married couples filing a separate return

Proposed law
A new top tax rate of 39.6% would apply for high income taxpayers. Combined with the Net Investment Income Tax (NIIT) of 3.8%, the result would be federal taxes on long-term capital gains and qualified dividends of 43.4% for those affected by the change. The higher tax rate would apply only to the extent that an individual’s taxable income exceeds the applicable threshold amounts indexed for inflation after 2023:

  • $1,000,000 for married couples filing a joint return
  • $500,000 for married couples filing separately

If enacted, it is proposed that this change would apply retroactively for gains and dividends received on or after the date of enactment.

Tax changes that could affect estate transfers and gifting

Surtax on estates and trusts

Current law
The current unified gift and estate tax exemption of $12.06 million per person (in 2022) is set to expire at the end of 2025. At that time, the exemption amount will be reduced by roughly half the current level. Previous proposals under consideration would have accelerated the expiration of the higher exemption amount to 2022, but this broad aspect of estate and gift taxation is not addressed by the Green Book. However, a number of other provisions are included.

Proposed changes
Unrealized gains on appreciated assets transferred by gift during life or held at death would be treated as a “realization event” for tax purposes and taxed as if the underlying property was sold. The unrealized gain of property transferred by gift during life or held at death would be subject to a $5 million lifetime exclusion for a single tax filer. Any unused exclusion during life can be applied towards the unrealized gain on property held at death. Also, the proposed exclusion would be portable and may be used by a surviving spouse. This results in an effective aggregate exclusion amount of $10 million that can be used towards unrealized gains by married couples filing a joint return.

Gains on gifts or bequests to charities would not be required to be recognized. Neither would gains on gifts or bequests to a spouse until the spouse dies or disposes of the asset. However, in both cases, the cost basis would carry over. This tax would apply on property transferred by gift after December 31, 2022, or property owned by individuals who die after December 31, 2022.

In addition, unrealized capital gains in appreciated assets would be taxed if they are transferred into or distributed in kind from an irrevocable trust, partnership or other non-corporate entity if such transfers are effectively a gift to the recipient.

Similarly, unrealized capital gains in appreciated assets held by an irrevocable trust, partnership or other non-corporate entity would be subject to tax if such property had not been recognized for tax purposes within the prior 90 years.

These rules would become effective on transfers, or for property owned by individuals who die after December 31, 2022.

New rules for donor-advised funds

Current law
Private foundations (PF) are generally required to make annual “qualifying distributions” of at least 5% of the aggregate fair market value of all a foundation’s assets that are not used to carry out its exempt purpose. Current law allows a PF to protect foundation assets by directing some of those distributions to donor-advised funds (DAF), where assets can be held for an indefinite period.

Proposed changes
The use of DAFs would be limited to avoid private foundation PF payout requirements by clarifying the definition of a distribution from PFs to DAFs. Such distributions would not be considered a qualifying distribution unless the DAF funds are expended as a qualifying distribution in the following taxable year. In addition to meeting that requirement, the PF must maintain adequate records or other evidence to that effect. This rule would be applicable on the date that it is enacted into law.

Tax laws related to GRATs and other trusts

Overview of current law
The creator of a grantor trust is treated as the owner of the trust assets for income tax purposes. This allows the grantor to manage transactions within the trust without realizing gains and to pay income taxes without it being considered a taxable gift. Several provisions of the new proposals would affect the operation of Grantor Retained Annuity Trusts (GRATs) and other types of trusts.

All changes proposed below could take effect on or after the date of enactment of the new tax law, unless otherwise specified.

Minimum and maximum value requirement for a GRAT

Current law
No minimum values are currently applied to GRATs.

Proposed changes
To fully qualify for favorable tax treatment inside the trust, the remainder interest established at the inception of a GRAT must have a minimum value equal to the greater of 25% of the value of assets transferred into the GRAT or $500,000 (but not more than the value of such assets). The term of the GRAT must also be a minimum of ten years and not exceed the annuitant’s life expectancy plus ten years.

Asset sales in grantor trusts

Current law
When a sale occurs between an irrevocable grantor trust and its deemed owner, it is not a taxable event.

Proposed changes
The sale of an asset between an irrevocable grantor trust and its deemed owner (grantor or any other person) would require the seller to recognize a gain on any appreciation in the transferred asset for income tax purposes. The buyer would be required to claim a cost basis equal to the value of the asset, which would include the satisfaction of an obligation, such as an annuity payment or note repayment, with appreciated property. This rule would not apply to securitized transactions.

Tax treatment of income paid by owner

Current law
If the deemed owner of the trust pays the income tax due from the trust, it is not considered a gift.

Proposed changes
If the deemed owner of the trust pays the income tax due from the trust, this would be considered a gift, unless the trust reimburses the owner for the tax payment in the same year.

Value of promissory notes

Current law
A common estate planning technique is to sell appreciated assets to a grantor trust in return for a promissory note. This essentially freezes the value of the appreciating asset in the estate, creating a significant wealth transfer opportunity.

Proposed changes
Promissory notes that bear sufficient interest to avoid below-market status would require consistent valuation. The discount rate used to value the note for gift and estate tax purposes would be the greater of the actual interest rate of the note or the applicable federal rate (AFR) based on the remaining term of the note. The proposal would apply to valuations as of a valuation date on or after the date of introduction.

Limit to generation-skipping transfer tax exemption

Current law
If sufficient generation-skipping transfer (GST) tax exemption is allocated to a trust, it makes the trust perpetually GST-exempt.

Proposed changes
The GST tax exemption would be limited to direct skips and taxable distributions from a GST trust to beneficiaries who are no more than two generations below the transferor (grandchildren). Those of younger generations would qualify for the same tax treatment if they were alive at the creation of the trust. Taxable terminations of a GST trust that occurs while any of these persons are beneficiaries of the trust would also qualify.

Tax changes that could affect businesses and business owners

Increase in corporate tax rate

Current law
The effective tax rate on C corporations is 21%.

Proposed changes
The new effective tax rate would be 28%, effective for tax years beginning after December 31, 2022. For taxable years that begin after January 1, 2022 and before January 1, 2023, only the portion of the taxable year in 2023 would be subject to the 28% tax rate.

Limits on family partners to shift tax basis

Current law
Family members can use a partnership to shift the tax basis of assets between each other.

Proposed changes
The new law would reduce the ability of family members to use a partnership to shift the tax basis of assets between each other. This would be effective for tax years after December 31, 2022.

Treatment of carried interest

Current law
A “profits” interest in a partnership received in exchange for services is typically not taxable when received. The recipient is taxed based on their share of partnership income and the character of the income at the partnership level.

Proposed changes
Tax-carried profits interests in a partnership would be treated as ordinary income and be subject to self-employment taxes regardless of the character of the income at the partnership level. This would apply to partners holding the interest and providing services to the partnership who have taxable income exceeding $400,000. The interest would only be treated as a long-term capital gain if there were a three-year holding period. The new law would be effective beginning after December 31, 2022.

Limits on like-kind (1031) exchanges

Current law
Section 1031 exchanges allow taxpayers to defer the full value of the gain when exchanging real property for other real property.

Proposed changes
The deferral of Section 1031 like-kind exchanges of real property would be limited to an aggregate amount of $500,000 for each taxpayer ($1 million for married couples filing a joint return) per year. This would take effect after December 31, 2022.

Limits on conservation easement transactions

Current law
There is significant flexibility to claim a deduction when establishing certain conservation easement transactions.

Proposed changes
A partner’s tax deduction in certain syndicated conservation easement transactions would be limited. A direct or indirect contribution by a partnership would not be treated as a qualified conservation contribution if the amount of the contribution exceeds 2.5 times the sum of each partner’s basis in the partnership.

There are important exceptions to this proposal. For example, the limit would not apply if a three-year holding period requirement was satisfied. It also would not apply to certain partnerships and other pass-through entities if substantially all of the interests are held by family members.

The new law would be effective for contributions made in taxable years after December 23, 2016, or in the case of contributions to preserve a certified historic structure, for contributions made in taxable years beginning after December 31, 2018.

Deductions for business-owned life insurance

Current law
A pro-rate interest expense deduction can be claimed for interest allocable to unborrowed cash values of business-owned life insurance policies covering employees, officers and directors of a corporation can be deducted.

Proposed changes
The deduction disallowance in these circumstances would be expanded to include policies covering employees, officers or directors. An existing exception for a policy covering a business owner with at least a 20% ownership position would remain. This would be effective for policies issued after December 31, 2021.

Previously proposed rule changes not included in the Green Book

The Green Book did not address some key changes to tax code that had been proposed in legislation under consideration in 2021. These include:

  • Repeal of the cap on Social Security taxes. The 6.2% tax on Social Security for each employer and employee applies to the first $142,800 of income in 2022. While some expected this cap to be removed, nothing to that effect was included under these proposals.
  • Change to gift and estate tax exemptions and tax rates. As indicated above, the current lifetime unified exemption amounts and tax rates for gift and estate remain at their elevated levels, with the current rules phasing out in 2026.
  • SALT limitation. There was much discussion of eliminating the maximum $10,000 deduction for state and local (SALT) taxes, but that issue is not addressed in the Green Book.

Start planning for a changing tax environment

The Green Book is just a starting point for legislation that may come under consideration in 2022. The timing of any legislation is difficult to predict, and much may revolve around the fact that all members of the House of Representatives and one-third of the members of the U.S. Senate are up for election in November. We will closely monitor events in Washington and keep you up-to-date on the latest proposals.

Talk with your wealth professional if you have questions about the potential impact on your own situation and financial plan.

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