DAVID P. BOEKELOO
David P. Boekeloo, JDDirector, Trust & Estate Servicesview bio

The Proposed Income Tax Changes Impact on Estate Planning

9/28/2021

Often when people think about estate planning and tax law changes, they think about increasing the transfer tax exemptions and their corresponding tax rates. But frequently, income tax changes have a bigger and more long-lasting effect on people as they create their estate plans. Not taking incomes taxes into account can be a profoundly serious mistake.
 
On September 12th, the House Ways and Means Committee released its long-awaited tax proposal, which would have a substantial effect on estate planning. This proposal must be considered, and planning strategies should be used to minimize their effect.

Change in the marginal tax from 37% to 39.6% for high-income taxpayers

A wealthy man whose taxes will increaseThe first change is an increase in the marginal income rate of high-income taxpayers. This rate would increase from 37% to 39.6%. This increased rate would apply to single individuals with incomes over $400,000 and married couples making over $450,000.
 
This increased rate would apply to a larger number of people than today’s 37% rate. Currently, the 37% rate applies to single taxpayers with incomes over $518,000 if single, and $622,000 if married. For estates and trust, the highest marginal rates would apply to incomes over $13,050.
 
These higher marginal rates would reduce the cash flow of high-net worth taxpayers, making it exceedingly difficult for them to enter into a creative estate planning strategy. The higher tax rates on trusts and estates mean a difficult choice may have to be made, whether to make distributions to beneficiaries who may have issues managing money or pay more money to the federal government.

Increase in the maximum capital gains and dividend tax rates to 25%

The House proposal would increase the highest capital gains and dividend rates from 20 to 25% for single taxpayers with income over $400,000 and married taxpayers with incomes over $450,000. Just like the increased marginal rates, they would apply to a much greater number of individuals. The biggest effect this might have on estate planning is on those taxpayers who own highly appreciated stocks which pay no dividends. Often it may be their intention to sell those stocks as they approach retirement, investing in a diversified income-based portfolio to provide for their retirement. If they wait to sell these assets, they may be faced with increased income tax liability, which would affect how much they could leave to their heirs. If, on the other hand, they sell their assets today at a lower capital gains rate and invest in a diversified portfolio they may end up with a lesser amount in retirement, due to investment performance which could also affect how much they could leave to their heirs.
 
This perplexing decision could put investors “between a rock and a hard place,” and should only be decided upon after thoughtful conversations with their tax advisor, estate planner, and investment professional.

A stock market chart showing capital gains

3% Income tax surcharge on top earners

The proposal would also impose a 3% income tax surcharge on individuals with incomes over $5 M, and on taxpayers with incomes over $2.5 M who are married and filing separately. More importantly, from an estate planning perspective, it would apply to trusts and estates with incomes over $100,000.
 
The impact of this surcharge on trusts is quite obvious; for a large account which has discretionary distributions and problem beneficiaries, it could result in the beneficiaries becoming subject to the 3% surcharge. In California, this could mean that a trust could be subject to the 39.6% income tax rate, the 3% surcharge, and the 13.3% state income tax rate for a whopping total of 55.9%. This rate is calculated before considering the 3.8% federal Net Investment Income Tax (NIIT) to be discussed later. If that tax applies, the trust’s total marginal rate for income over $100,000 would be 59.7%.

Ways to reduce your tax rate

Investment income tax planning is essential to determine ways to reduce this extremely high rate. One possible way is to invest in municipal bonds, which are not subject to income tax. Another approach would be to invest in stocks which pay no dividends, and a third approach would be to invest in private placement life insurance, which is both tax-deferred and can have distributions paid out without incurring income tax liability.
 
Each of these methods possess both positive and negative implications and can only be decided upon with input from tax and investment professionals.

The 3.8% Net Investment Income Tax (NIIT)

The 3.8% Net Investment Income Tax (NIIT) is proposed to apply to trade or business income in addition to investment income on property held to produce income. NIIT, however, would apply only to single taxpayers with incomes over $400,000 and joint taxpayers with incomes over $450,000. NIIT would not apply to taxpayers whose trader business income is subject to FICA. This exception comes into play when dealing with the owner of an S corporation.
 
A successful attorney whose income puts her in a high tax bracketHere's an example of the effect:Joe and Janet Jones are a highly successful couple; Joe is an executive in a publicly held company making over $500,000/year, and Janet is an attorney with her own S corporation where she produces $500,000/year of income. Currently, she takes a salary up to the Social Security wage base, which in 2021 is $142,800. All her remainder income passes through to her as K-1 income and would not be subject to the 3.9% Medicare tax. If this proposed tax change passes, Janet would be taxed 3.8% on all her K-1 income, which would eliminate the strategy of trying to avoid the Medicare tax. She and others like her would have to consider the appropriate entity for their business. This decision would have huge ramifications in business succession planning and would affect what the business owners’ heirs would receive and by what method.

Changes to retirement plans and IRAs

The House proposal has also several changes to mega retirement plans and IRAs. Taxpayers with IRAs and defined contribution plans between $10 M and $20 M must take a 50% distribution of the excess. When the retirement plan reaches $20 M, there is a 100% distribution of the excess.
 
Here's how this would work. Joe Physician has $25 M in his retirement plan. He must take 100% of the amount between $20 M and $25 M. Once the account balance reaches $20 M, he must take a 50% distribution of the amount between $10 M and $20 M. In total, Joe would take a $10 M taxable distribution. If the next year his retirement grows to $18 M, he will have to take a $4 M distribution.

These new distribution rules will cause people with very large IRAs to be reduced significantly in value, leaving much less to their heirs.

Modifications to corporate taxes

There are also several different proposals dealing with corporate taxpayers. Currently the corporate tax rate is 21% for every corporate taxpayer. The House proposal replaces the fixed-rate with a graduated system. For small corporate taxpayers with incomes under $400,000 the tax rate would be reduced to 18%. For corporate taxpayers with incomes between $400,000 and $5 M, the tax rate would remain at 21%. For taxpayers with incomes over $5 M the rate will be increased to 26.5%.
 
If the proposed changes become law, really small business owners should consider becoming C corporations because of the lower tax rate for incomes under $400,000 and the increased tax rates for individuals.

Section 1202 and Section 199A revisions

One of the most important provisions for business owners considering the sale of their businesses is Section 1202. This section allows owners of C corporations to sell their stock and exclude either 50%, 75%, or 100% of their gain, depending upon when their corporations were first formed.
 
At the present time, the exclusion is limited to the greater of $10 M or 10 times basis, which can be as high as $500 M. The House proposal would limit the deduction for single taxpayers with income over $400,000 and married taxpayers over $500,000. For these taxpayers, the exclusion would be limited to 50%, no matter when the corporation was formed.

People who are considering using 1202 should consider ways to reduce their taxable income in order to qualify for the full deduction. This would increase the benefit of this succession planning strategy and leave much more to their heirs.

Owners of a corporation who have to decide how to structure to avoid high taxes

Presently, Section 199A equalizes pass-through businesses with C corporations. 199A gives a 20% deduction to taxpayers with qualified business income. The law limits the deduction available to so-called specified trade or businesses; generally, there is a phase-out of the deduction for qualified trade or businesses at $329,800 for married couples filing jointly with a complete phase-out occurring when their income reaches $429,800.For non-trade or businesses, the deduction often is determined by either the amount of depreciable assets owned or by the number of employees working for the business.

The House proposal would limit this deduction to a total of $400,000 if single and $500,000 if married filing jointly.

Taxpayers need to assess their income structure

Taxpayers need to evaluate their entire income structure to determine the number of deductions they are to receive, and whether being an S corporation makes sense going forward. This determination is especially important, considering that trade or business income will now be subject to the NIIT Tax and taxpayers will get a 3% surcharge for incomes over $5 M. Making the wrong decision could have several adverse effects and cause the valuation of the business to be reduce substantially and affect what the heirs would receive.
 
The creator of a trustHere's an example of how the income tax proposed changes could affect estate planning. Joe Nguyen funded a trust with $5 M for the benefit of his three children, Harold, Lucy, and Richard. The trust in 2022 will have a taxable income of $500,000.

The trust distribution standard is discretionary only, as determined by the trustee. Harold is about to be divorced, and the trustee has determined that no distributions will be made to him. Lucy is suffering from a severe addition to opioids, and the trustee will not be making a distribution to her. To avoid the 3% surcharge for trust income over $100,000 the trustee will need to make a $400,000 distribution to Richard, but Richard is a successful plastic surgeon and does not need the money.
 
By investing in assets that do not produce substantial taxable income, this perplexing choice could be avoided. If the House bill passes, all trustees will have to determine if these increased tax rates will cause problems with their trust and will need to consider the size of the trust and the character of their beneficiaries. Thoughtful consultation with tax, legal, estate planning, and investment professionals will be essential.

Planning is necessary

Significant income tax strategies may be coming that affect individuals, trusts, and businesses. Planning must be done to avoid an estate planning nightmare.  
 
Often people do not consider the effects of income tax on their estate planning, This is a serious mistake unless one wants to leave more to the IRS and less to their heirs.

Disclaimer:
This content is prepared solely to provide general information to our clients and community.

This content does not constitute accounting, tax, or legal advice, nor is it intended to convey a thorough treatment of the subject matter.

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