As originally published by Medical Journal Houston, written by Catherine Lightfoot, CPA, CHBC

The proposed bill to help fund President Biden’s “Build Back Better” spending plan continues on its circular journey — from the House Ways and Means Committee to the House of Representatives, to the Senate, and then back again — until there is a version with enough votes to send to the President. In the meantime, how do you plan while you are awaiting the conclusion? Regardless of the discussion and confusion around this bill, there seems to be a basis for expecting sweeping tax changes. If the current version is passed without any modifications, this will be one of the largest tax hikes on high-income individuals in decades. Since it still has a long way to go, it is likely to undergo several iterations before the final version is approved. However, there are certain key elements of the proposal that are important to understand and start planning for at this point in time.

Tax Rate Increases

Ordinary Income

The tax proposal seeks to increase the top ordinary tax rate and lower the income threshold to which it applies to taxpayers for tax years beginning after December 31, 2021. The top rate would increase from 37% to 39.6%, which is the rate we had prior to the Tax Cuts Jobs Act of 2017. The more significant change is that, under the new proposal, this rate would apply to taxable income over $400,000 for single taxpayers, $450,000 for married taxpayers, and $12,500 for trusts and estates. Currently, the top rate of 37% applies to taxable income over $523,600 for single taxpayers, $628,399 for married taxpayers, and $13,050 for trusts and estates. For example, a married couple with $600,000 in taxable income would pay an additional $3,900 in taxes due to the anticipated rate change and threshold reduction.

Whenever there is a possibility that the income tax rate will be higher in the following year, the game plan is to accelerate income or defer deductions, or some combination of the two. For many years businesses have enjoyed the 100% deduction that bonus depreciation offers. However, the “election” to write off 100% of the asset purchase applies to those assets with under a 20-year life and is made by class life. Make sure your accountant has an accurate description of the assets you purchased in 2020, so that they can be categorized by the correct life. This year, it might be better to elect 100% bonus for some of your asset groups and save others for ongoing depreciation deductions into the subsequent tax years.

Capital Gains and Qualified Dividends

Long-term capital gains are generated by the sale of assets held for longer than one year. The current proposal would increase the top capital gains tax rate from 20% to 25%. This would apply to taxpayers in the top ordinary rate of 39.6%, and it would be effective for long-term capital gains recognized after September 13, 2021. The original “effective date” was sometime back in April. Now it is already October, making it difficult for taxpayers to plan. As a reminder, capital gains and losses are netted before they are taxed. Your investment advisor should be able to recommend capital losses to “harvest” to offset any gains recognized after the effective date, whenever that turns out to be. Harvesting is a term used for the act of selling a stock with a realized loss, so that you can recognize the loss and use it to offset gains.

Net Investment Income Tax

The 3.8% net investment tax currently applies to a broad class of investment and passive income. The pending proposal significantly expands the definition to include net income derived in the ordinary course of a trade or business for taxpayers in the top 39.6% bracket. This would effectively close down the long perceived “loophole” tax advantage to running a business through an S Corporation. Tax planning and entity selection for new business ventures will look a lot different in the future if this becomes law.

Retirement and Estate Planning

Roth IRAs

The bill would eliminate Roth IRA conversions for those in the 39.6% tax bracket beginning in 2032. If passed, planning over the next several years would be critical for those wanting to move IRA balances over to Roth plans. Many taxpayers who are ineligible for contributions to regular IRAs have been utilizing a “back door” method of funding Roth IRAs. This method takes an IRA funded with after-tax dollars, otherwise known as a nondeductible IRA contribution, and immediately converts the account to a Roth IRA. This back door to a Roth account would be prohibited starting in 2022. Therefore, if you have ever wanted to shift some of your retirement funds to a Roth, this might be the last year to take advantage of this tax strategy opportunity.

Estate and Gift Tax

The 2017 Tax Act temporarily doubled the amount of assets individuals may pass to heirs without paying gift or estate tax. For 2021, this amount is $11,700,000. The proposal would take the exclusion back to $5,000,000 with an inflation adjustment. For 2022, the exclusion is estimated to be $6,020,000 — reducing the exclusion amount four years earlier than scheduled. The reduced exclusion would apply to gifts and estates of decedents passing after December 31, 2021. Individuals should review their estate plan with their advisors for potentially accelerating gifting timelines.

How to Minimize the Tax Impact

Once again, it is important to note that taxes are only one part of a solid wealth strategy plan. Major decisions should not be made until a final tax law is known, hopefully in the near future. But there are some ways to minimize the impact starting based on what we know today.

Here is a summary of action items you may want to consider before the end of the year:

  • Accelerate income into 2021 in anticipation of higher tax rates in 2022.

  • Review asset class lives on purchases and categorize them for the best depreciation elections. Push later equipment purchases into the first quarter of 2022.

  • Hold appreciated stocks until the effective date is confirmed. Review any stocks with loss potential.

  • Review current IRA accounts for tax basis and value. Consider Roth options.

  • Review gifting ideas with your estate advisor.

Many of you have just finished your first round of PRF (Provider Relief Funding) reporting with rules released on July 1st that were completely different than what was published earlier this year. If we have learned anything over the past several pandemic months, it is that government policy can and will continue to change in an unpredictable way. Tax policy is no different. It will be an interesting year end.