Last Friday, on the eve of the long holiday weekend, the White House released President Joe Biden’s $6 trillion budget to the public, providing more clarity on his priorities for the country and on the methods he would like to use to fund these initiatives, including higher taxes on individuals and families that have accumulated wealth or have higher earnings. The budget contained two parts, the “American Jobs Plan” and the “American Families Plan.”
The American Families Plan proposes two significant changes to capital gains tax laws of particular interest and concern to ultra high net worth families, which we want to highlight:
1. Tax capital gains at ordinary income rates for those with annual income over $1 million.
If passed, this would increase the top marginal individual income tax rate to 39.6% beginning on January 1, 2022. According to the Treasury Department’s “Green Book,” which provides detailed explanations of the budget proposals, the top marginal tax rate would apply to taxable income over $509,300 for married individuals filing a joint return for 2022 and $481,000 for head of household filers, $452,700 for unmarried individuals (excluding surviving spouses) and $254,650 for married individuals who are filing a separate return. (The Green Book does not indicate how non-grantor trusts and estates will be taxed, but historically, trusts and estates have been treated consistently.)
Assuming the top marginal tax rate becomes 39.6% as the budget proposes, and adding in the net investment income tax (NIIT) of 3.8%, long-term capital gains would be taxed at 43.4% for individuals earning over $1 million ($500,000 for married people filing separately).
If the budget is passed in its current form, this would affect gains recognized after the date of the announcement (although it is unclear whether this refers back to when the American Families Plan was first announced in April or when the budget was released on May 28. Either way, this could be a trap for taxpayers who have already locked in gains).
2. Treat the transfer of appreciated property as a tax realization event, where taxes would become due (eliminating the tax-free step up in basis for assets passed at death).
Current law provides that an asset held by a decedent at death will have its basis “stepped up” to fair market value before it is passed to an heir, thus avoiding capital gains tax on the asset’s appreciation during the decedent’s lifetime.
The American Families Plan proposes that when an asset is transferred, the transferor (either the donor during lifetime or the decedent after death) would have a “deemed sale” and would realize a capital gain on appreciated assets and owe taxes (as if the asset had been sold). Transfers affected by these “deemed sale” rules include:
- A person making a gift of assets during their lifetime (except for qualifying gifts to a spouse or charity as noted below).
- Upon death (again, except for qualifying transfers to a spouse or charity as noted below).
- Property transferred into a non-grantor trust, partnership or other non-corporate entity.
- Property distributed from a non-grantor trust, partnership or other non-corporate entity.
- Distributions made from a grantor trust to anyone other than the grantor or the grantor’s spouse.
- A grantor trust becoming irrevocable.
Note that the resulting capital gains taxes are in addition to any gift or estate taxes that would be due as a result of these transfers, although the taxes imposed on a deemed sale at death would be deductible on the decedent’s estate tax return to partially offset the estate tax.
Importantly, in a swipe at dynasty trusts, this proposal would also tax unrealized appreciation that has occurred on assets in trusts, partnerships or other non-corporate entities, if those assets have not had a recognition event during the last 90 years. The first possible recognition event would be December 31, 2030. (For non-liquid assets transferred at death, a 15-year, fixed-rate payment plan would be available to ease the pain of paying these capital gains taxes and avoid the need to liquidate the applicable asset.)
Notable exceptions in the budget proposal:
- A per-person lifetime exclusion would shelter up to $1 million in appreciation on property transferred by gift or at death ($2 million per married couple).
- Assets transferred to a spouse would carry over the decedent’s basis, and recognition of gains would not occur until the surviving spouse dies or disposes of the asset. However, it is unclear what forms of lifetime transfers (besides outright gifts) to spouses will be eligible for this exclusion.
- Assets donated to charity would carry over the decedent’s basis but not create taxable capital gains.
- For assets donated to a split-interest trust, an exclusion would be allowed only for the charity’s portion of the split interest gift.
- No gains would be recognized on appreciation of tangible personal property (your personal effects, furniture, etc.), except for collectibles.
- Capital gains on a principal residence would still be subject to the current $250,000 exclusion per individual ($500,000 per married couple due to portability).
- Certain small business stock would still benefit from the currently existing exclusion.
- Payment of the tax on deemed transfers of certain family-owned and family-operated businesses would not be due until the business is no longer owned and operated by the family. However, what businesses will qualify is not spelled out in the Green Book. (This appears to be a repackaging of the Family Owned Business Exclusion applicable to certain businesses under prior law.).
This proposal would affect all gains on gifts of assets after December 31, 2021, and property passed at death after December 31, 2021. According to the Green Book, it would also affect “certain property owned by trusts, partnerships, and other non-corporate entities on January 1, 2022.” These effective date provisions mean that taxpayers may have a window until the end of the year to reposition assets for their family before these changes would take effect.
In many respects, these changes are similar to the “STEP Act” proposed by Senator Van Hollen, which we discussed in a recent Legacy Matters blog post (available here). These changes would also create significant basis tracking obligations and compliance requirements which may further reduce people’s willingness to transfer assets other than cash.
Budget Proposal Wrap Up
The Green Book is silent concerning any changes to estate, gift and generation skipping transfer tax exemptions and tax rates. Presumably the president is not proposing changes to these provisions of current law and perhaps will be content to let exemptions return to the previous level of $5 million (adjusted for inflation) as scheduled in 2026 without the need for congressional approval.
These would be significant tax law changes if enacted, but this is simply a budget proposal which still needs to go through the legislative process to be passed, and a few of these items will likely inspire some controversy in Congress. The tight margins in both houses of the Congress mean that any tax law change could be difficult to pass in its current form, and we cannot predict what tax items the final budget will contain.