Michael Fischer, CFP, director and wealth adviser for Round Table Wealth Management, provides an in-depth exploration of the preliminary proposal recently presented by U.S. House Democrats to fund President Joe Biden’s $3.5 trillion spending package. As part of his examination, Fischer looks at the impact it could have on the tax landscape for individuals, retirees, businesses, and more.

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By: Bill Hayes, Pennsylvania CPA Journal Managing Editor

Podcast Transcript

The preliminary proposal recently presented by House Democrats to fund President Joe Biden's proposed $3.5 trillion spending package would have a profound impact on the tax landscape. Potential areas affected would include income taxes, retirement plans, estate taxes, and more. To walk us through the potential changes, today we have with us Michael Fischer, director and wealth advisor for Round Table Wealth Management in Westfield, N.J.

House Democrats recently presented a preliminary tax proposal to fund President Joe Biden's proposed 3.5 trillion spending package. Let's go over some of the changes in key areas. How about income taxes? What would be some of the changes there?

[Fischer] It's been a bit of a hectic year trying to figure out how exactly Congress is going to start implementing some of the changes that Biden had been discussing for the last almost two years at this point. I think we've seen three or four proposals this year, with each one giving us a little bit more clarity as to what they're ultimately going to look into taxing. I think that this current proposal, which was introduced in mid-September, looks right now that it's still lacking some of the votes needed in both the House and the Senate, but this is kind of the framework that we have to work with for today. With respect to income taxes and brackets, I think what we've seen most consistently is the top marginal rate of 37% looks like it's going to be increased to 39.6%, which is a return to where it was back in 2016.

What's new in the current proposal is that this is looking like it's going to apply to income in excess of $400,000 for individuals and $450,000 for married filing jointly. That's going to be a huge erosion of the existing 35% tax bracket, especially on the married filing jointly side. The original proposals were looking at that number to be closer to $625,000 of income. If you have any clients who are married making $500,000 a year and get a bonus around year-end or the beginning of next year, it may be an effective strategy to recommend taking that bonus in 2021, rather than getting it in 2022. There's also a 3% surtax applied on modified AGI in excess of 5 million. Those ultra-high earners will be paying an effective marginal rate at the top of about 42.6% starting next year.

With capital gains, it's actually a little bit less punitive than what was originally feared. There had been some discussion of eliminating the preferred treatment of capital gains at certain income thresholds, whether it be $400,000, million dollars, but that seems to be off the table at the moment, but the 20% maximum capital gains rate looks like it's going to be increased to about 25%. This piece of the legislation. We still don't have a lot of clarity on. What is clear is that it's not going to be effective at the beginning of 2021. There's been talk about it being effective when it's introduced to Congress, which was September 13th of this year. But given that it's kind of mid-October right now, and we still don't have clarity as to when it will be effective, we're kind of hoping that this is something that's going to apply in 2022 and going forward. This top rate also applies to qualified dividends. It's important to keep in mind the net investment income tax of 3.8% is still applied as well.

The highest marginal rate is closing in on 29% for capital gain going forward. Then the last one is just a small update. Cryptocurrency is now going to be subject to some of the rules that we see apply to other investments, most notably wash sale rules. This is an area that's kind of been like the wild, wild west over the last couple of years. I know that Congress and the IRS are looking to close the loop on a lot of these transactions that have gone untaxed in the past.

How would retirement plans and accounts be affected?

[Fischer] I was actually pretty surprised to see an entire section in this legislation addressing retirement accounts. I think that the big push here was earlier this year there was a report that Peter Thiel, founder of PayPal, early investor in Facebook, had a $5 billion Roth IRA that would otherwise save taxation pretty much indefinitely. The proposal would limit retirement account balances to 10 million per individual, and it would accomplish this by phasing out the ability to make contributions after achieving that account balance. By forcing required minimum distributions, regardless of the investor's age. I don't see this applying to very many individuals. I think it's hard to amass that amount of money within a qualified plan, especially because profit-sharing plans, 401Ks IRAs, and Roth IRAs have significantly lower contribution limits. The piece of the legislation that I think will apply to a broader base is that tax-deferred accounts will now be prohibited from holding investments that require the account holder to be an accredited investor.

An accredited investor is somebody who meets a certain asset level, income level, or financial knowledge requirement. This typically deals with hedge funds and private equity investments. With a lot of clients who do their private-equity investing and hedge fund investing within IRAs, mainly because it helps from a tax reporting standpoint, these investments would ultimately need to be liquidated to be compliant within the new regulations. Nobody has to panic right now. There is a couple-year grace period here. It does allow for some time to unwind those positions and figure out how you want to make those investments going forward.

The last thing, and I think that this will apply to the broadest base here, is going to be the closing of the backdoor Roth IRA loophole. Where high income earners, who wouldn't otherwise be allowed to contribute to a Roth IRA, could make a taxable IRA contribution and then convert it to a Roth IRA shortly after that. That would be eliminated at the end of 2021. There would be reinstituted an income eligibility threshold for future Roth IRA conversions. So, if you have an IRA and you're making too much money going forward, you wouldn't be able to convert that into a Roth IRA in the future.

What sort of shift or changes could we see in the area of estate taxes as a result of this?

[Fischer] Again, the big headline here is the reduction of the estate tax exemption from about $11.7 million per person today to somewhere around $6 million next year. This would actually be the first time that the estate tax exemption has ever been reduced. It creates a really interesting “use it or lose it” scenario when it comes to gifting in 2021. I would expect attorneys to be very busy setting up spousal lifetime access trusts, or SLATs, for clients who didn't get around to doing this last year. While the estate tax exemption is the big headline, I think it's some of the changes to what we can do as planners that is really the key issue here. So, valuation discounts, which we commonly use in transferring assets from a parent to a child, something like that, usually used in businesses. In some cases, we've done things with LLCs or family limited partnerships that just hold marketable securities, the legislation would limit the applicability of those discounts just to actively manage business assets.

You can no longer take a discount on something like a portfolio of stocks. The other planning tool, which has become increasingly popular in the last couple of years, has been the use of an intentionally defective brand to a trust. So, this type of trust, you basically include certain provisions, exclude certain provisions, which allow it to live outside of your estate for estate planning purposes, but included for income tax purposes. It kind of lives in two separate worlds. That creates some planning opportunities like a sale to an intentionally defective grant or trust without having to recognize income there. This legislation is looking to marry those two things. It's either included for estate purposes and income tax purposes, or it's outside in both cases. So, looking to clean up a couple of those, what people like to call, loopholes so there's a little bit more consistency in the tax code.

Would corporations and businesses experience a shift in taxes as a result of this?

[Fischer] I will caveat this section. Look, I'm not a corporate tax expert. I'm not an accountant. There are plenty of professionals and planners who deal almost exclusively within this world, working for multinationals and huge corporations like that. There are going to be some changes with the GILTI tax, the BEAT tax, and with respect from some overseas subsidiaries. If that's an area that you specialize in, I'm confident that you've already looked at and digested some of that. My focus is mainly on my clients who have small domestic businesses, and they've really benefited over the last couple of years from the reduction of that 35% corporate tax rate a few years ago to the 21% that we have right now. The Biden administration has really made it a priority to start taxing some of these corporations at higher levels.

You saw earlier this year the attention to Amazon paying such a low corporate tax rate. The solution here, and I think it's actually a pretty good compromise, is a more graduated corporate tax system. Similar to what we have on the personal side, where rates get higher the more income you have. We would have that going forward on a corporate tax basis. So, 18% up to $400,000, 21% between $400,000 and $5 million, and then 26.5% on top of that. It's important to note that corporations with $10 million in income would lose the benefit of those lower graduated rates, which creates a corporate tax cliff for corporations that are right on the border there. That might be an area where there's a strong focus on planning going forward. I do think that this, from the corporate side, is a win for small businesses, because a lot of businesses are going to be in that 18% bracket.

That's huge going forward. It's not necessarily punitive for larger corporations as well, as they were paying 35% just a few years ago. That's on the corporate side. On the flow-through entity side, there's been a discussion of limiting the qualified business income deduction to $500,000 for married, $400,000 for individuals. This was new in 2017, and it was previously uncapped. But it's important to keep in mind that this really is targeted at specific industries. It excludes a lot of us who are listening on the call. Personal service, health, actuarial accounting. All of those things are excluded from this, and they were in the past as well.

Is there anything that hasn't been included in the proposal that people should be aware of that maybe they thought would be addressed but wasn't?

[Fischer] The big one right now, and I'm sure you're seeing it in the news, has been the SALT deduction. House Democrats, especially in our home states here and in the Northeast, have really been feeling the pressure from their constituents, who, in a lot of cases, their property taxes exceed $10,000. That limit is not addressed in the current legislation. I have seen them talk about raising that cap, something like $20,000, maybe phasing it out, doing something like that, which I think could get a little bit more support, and would help this ultimately to get passed. The second area, which we really saw a lot in Biden's early proposals has been about eliminating or revamping the step-up basis at death. Earlier, it was talked about from dollar one of tax and gains.

I had seen a proposal over the summer that was talking about increasing that to basically a million dollar exemption, but then paying income tax on top of that. It's something that seems to be gaining some support. Former President Trump actually campaigned a little bit on it in 2016. I just think that there are so many logistic hurdles. I was with a client the other day who had stock certificates for something bought in the 1970s. They obviously don't have cost basis on that. It's something that, as we go forward, I think will be addressed. But in this bill I don't expect it to be an attention item going forward.

Then the third thing would be relatively small and kind of nuanced. But I had seen some talk about eliminating the 1031 Exchange, which is a real estate provision that allows investors to lay the recognition of capital gains on the sale of an investment property, as long as it was used to purchase a replacement property. That looks like something that real estate investors will have available to them going forward. Then, not necessarily tied to the bill, but Social Security continues to be a huge issue. You're seeing in the news the impact of COVID has cut a year or two off of when they expect to continue to be able to pay benefits through. Biden's campaign was to increase Social Security tax on those making more than $400,000. I think that that's something that will ultimately be addressed during this administration. I just don't think it's going to be aligned in this bill right now.

As we step out of the idea of taking a look at what's in the bill and just go for a more general outlook here, how important is it for financial planners and financial planner CPAs in general to be aware of the goings on in this area, so that they can do the best job they can to counsel their clients?

[Fischer] I think it's pretty critical to stay up to date on this stuff. I know it's hard to know how certain some of these things are, especially because, look, this is the fourth time I've gone through some of these bills this year, so these things keep changing. But it's important when you're having conversations on our side with CPAs or on your side with financial advisors to really stay on top of this so that we can provide kind of the best advice for our clients. Because huge dollars can be saved here by making the right decisions, either deferring income, taking income into this year, or managing brackets effectively.

I think that this is an opportunity where we can really do right for our clients. That advice goes a long way, because doing right for your clients is a great reward in itself. But when another advisor, if you see a financial advisor who's doing a great job with his or her clients, it can result in more referrals. It can result in referrals directly from the client. It's really an opportunity to add some value and provide the best advice for the people that we serve.