Democrats on the House Ways and Means Committee released legislative text for proposed tax changes Monday, September 13. This proposal will raise tax rates for corporations and high-income earners as well as make changes to the Internal Revenue code. Although this has not yet been passed, we would expect that much of what has been proposed will make it into the final bill.
We have dissected the proposal and assembled a few highlights and will focus on 3 categories:
- Tax increases and elimination of tax strategies for individual income taxes
- Tax increases for business, in particular S Corporations
- Estate Tax changes and the planning implications
We will also touch on a few areas that were not covered in the initial language that may still be on the table.
Individual Income Taxes
One of the key changes in this proposal is to increase the top rate tax rate back up to 39.6%, which was expected. However, one of the biggest changes as a part of this is the compression of the 35% tax bracket, meaning you will hit the top tax bracket much more quickly. For single filers, you will hit the top bracket at $401,000 of income vs $523,600 previously while joint filers will hit the top bracket at $450,000 of income vs $628,300.
In addition, the “marriage penalty” was brough back in a big way. The most recent tax changes set up the brackets so that as you moved up the brackets, married couples essentially got a doubling of the single income levels before they would pass to the next tax bracket. This proposal dramatically changes that at the 35% bracket by only have about $50,000 on income eligible in that bracket before you hit the top rate. While it is tough to make marriage decisions based on income taxes, it will force many, especially those who are not married yet, to at least have the conversation around whether it makes sense financially to tie the knot!
Long-Term Capital Gains Rate
While many feared a that we would see the top rate for capital gains tax aligned with the top income tax rate, what we are seeing at this point is a much smaller increase – from 20% to 25% on Long Term Capital Gains. However, income when this higher rate kicks in is much lower, $400,000 for single and $450,000 for married filers whereas the previous guidance would be that the top capital gains rate would not kick in until $1,000,000 of income. In addition, this was the one change that took effect immediately upon the release (if the bill is passed) so that any transactions that occur after September 13 would be subject to the higher rate. The are a few exclusions to this, primarily if you had a binding contract to sell your business in place prior to September 14.
Goodbye to the Backdoor Roth IRA
Due to income limit rules, many middle to high income earners have not been eligible to contribute to a Roth IRA. However, there are rules in place that have allowed a “back door” into funding a Roth IRA through an After-Tax Traditional IRA contribution and then converting that to a Roth IRA with little or no tax consequences. In addition, some 401ks allowed or a “mega back door” Roth strategy by allowing as much as $58,000 in after tax contributions that could be converted. These strategies are dead in the water under the new proposal as well as a phase out of the ability to do any Roth Conversions at all for higher income earners in 10 years.
Changes for Business Owners
There were 2 changes proposed that specifically impact business owners utilizing an S Corporation designation. Currently, profits of S corporations are NOT subject to employment tax or Net Investment Income Tax (NIIT), a 3.8% surtax that was implemented on investment income above $200,000 per year back in 2013. This bill would now subject S Corporation earnings to this tax, with some phase-ins at $400,000 of Modified Adjusted Gross Income (MAGI) for single filers and $500,000 for joint filers.
In addition, for very high-income S Corporation owners, there will be an additional 3% surtax for incomes above $5 million. For those business owners, this potentially makes their effective highest tax rate 46.4%.
C Corporations were not spared either, replacing the current 21% flat rate, the proposed graduated rate starts at 18% on first $400,000, 21% on income up to $5 million, 26.5% on income above $5 million. This graduated rate would phase out for corporations that make more than $10 million.
Estate Tax Changes
The Proposal would revert the unified credit against estate and gift taxes to $5 million per taxpayer for 2022 and in the future, adjusted for inflation, which works out to an estimated $5.8 million, or about half of what the current exemption is. This was highly expected to be a part of the proposal is it really is just pushing forward the changes that were set to happen in 2026 with the sunsetting of the previous tax law changes.
What makes this change a bit more challenging is that it also eliminates many of the planning strategies that were used to move assets out of an estate so that estate taxes could be mitigated, primarily through Grantor Trusts. The specific details of these changes are pretty technical and beyond my ability to simplify in this shorter post but suffice it to say that many of the acronyms you may have come used to hearing from your advisors, like GRAT, SLAT, IDGT and ILIT will not longer be valid strategies.
What Isn’t in the Proposal
While many of these changes were expected, there were a few changes that did not make it into this proposal that many anticipated, and could ultimately make it into the final version. I already mentioned the Long Term Capital Gains rate not aligning with the top income tax rate. Another big one was a fear that there would be a loss in the Step Up in Basis rules that allow for assets to pass to the next generation without requiring taxes to be paid on the growth of that asset. The other one that was missing was any change to the SALT deductions that were severely reduced in the last tax bill. I would expect that there will be a push in Congress to get something added to address that when the final bill goes for a vote.
What Can You do?
At this point, these are only proposals so it is tough to make any decisions without knowing for sure what will pass. However, based on when these changes take effect, it is important to do some planning before year end if you will be impacted. One could include considering shifting income into this year to take advantage of the lower rates. Also, if you do have significant assets and have not taken advantage of the much higher lifetime exemptions, you should consider preparing to make gifts before the end of the year utilizing some of the techniques that may not be available after January 1, 2022.
At Konvergent, we are already proactively beginning to review the impact of these changes for our clients. If you are not already working with us and have questions about how you might be impacted, please do not hesitate to reach out and set up an introductory call by sending an email to email@example.com.
This is general information and circumstances may vary based on the state in which probate is occurring. Talk to as estate administration professional for specific guidance to determine what is accurate and relevant for your situation.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.