2021 Tax Planning: A Glimpse of What
by Tanya Silves, CPA
President Biden introduced the American Families Plan in Spring 2021, which called for increases in spending and taxes. Biden’s plan was not actual legislation, but more of a guide for future legislation. The House Budget Committee has now advanced a $3.5 trillion budget reconciliation bill to the House floor with a vote currently scheduled for the end of this week.
Meanwhile, the Senate is developing its own version of the reconciliation bill. The final version of the Build Back Better package that President Biden enacts into law will most likely vary from the current draft legislation. It is impossible, however, to determine which proposed tax law changes will be retained at this stage in the legislative process. While the tax landscape remains uncertain, some of these proposals would take effect on the date of enactment and be retroactive, and others would take effect January 1, 2022. Those likely to be impacted should act now to take advantage of significant planning opportunities that may no longer be available after year end.
What is Tax Planning?
Tax planning is the process of analyzing your financial situation from a tax perspective with the objective to ensure tax efficiency. Tax planning is a significant component of personal and business cash flow planning. Tax planning comprises various considerations such as year-end expectations, the timing of income, and the timing and type of purchases and retirement investments.
Once we understand your current estimated tax liability, we’re able to produce scenarios that demonstrate the impact of these planning considerations in order to optimize your personal tax situation – either by reducing income to ensure you are paying tax at the lowest rates possible, increasing income to take advantage of low rates, or utilizing available credits, exemptions, etc. Tax planning should be performed well in advance of the turn of any calendar year to allow you time to make decisions and implement the plan developed and should take a holistic view of all your financial elements and how they work together both in the current year and years to come.
Benefits of Tax Planning
Proper and proactive tax planning can offer you both short and long-term benefits. Not only can you reduce the amount of tax you or your business pays, but tax planning can provide you some great insights into your future goals.
For example, businesses may learn whether the structure of the business needs to change, understand where operations are occurring, get a better grasp of potential profit areas and find new investment options.
Meanwhile, individual taxpayers can benefit from analyzing their holistic financial picture and begin the conversation around personal financial, retirement and estate planning.
Regardless if you are tax planning as an individual or on behalf of a business — tax planning gives you the peace of mind to make informed decisions by eliminating a stressful surprise and understanding and planning for your tax liability in the future.
Key Areas for 2021 Tax Planning
Proper tax planning requires an understanding of what's new and what’s changed from the previous year — and there are plenty of tax law changes and updates for the 2021 tax year that you should know about. In this document, we’ll briefly cover some of the more important proposed tax changes from the House Ways and Means Committee.
Individual Federal Tax Rate
Raise the top individual income tax rate to 39.6 percent for single filers making above $400,000, for head of household filers above $425,000, and for joint filers above $450,000.
Net Investment Income Tax
The net investment income tax of 3.8% would expand to include income from active trade or businesses of a pass-through entity which is not subject to FICA tax (such as rental income activity from an LLC.) This would apply to high earners and subject most income from pass-through entities to a 3.8% tax.
New 3% Surtax
The bill introduces a new 3% surtax on modified adjusted gross income in excess of $2,500,000 for married individuals filing separately, $100,000 for estates and trusts, and $5,000,000 for all other individuals.
Capital Gains Tax
The bill proposes to increase the highest capital gains tax rate from 20% to 25% for gains realized after September 13, 2021 and adjust the top capital gains tax bracket to $400,000 for single filers, $425,000 for head of household filers, and $450,000 for joint filers. If you add the 3.8% Net investment income tax and the new 3% surtax, it would result in an aggregate capital gain tax of 31.8% for the highest earners. The plan does not include Biden’s proposal to impose income tax on unrealized gains held at death, which would end the so-called basis “step-up”.
Qualified Business Income Deduction
The Qualified Business Income Deduction (QBI Deduction) would be limited to $500K for married filing jointly, $250K for married filing separately, $10K for trusts, and $400K for all others. The QBI deduction is 20% of qualified income, so this would affect business owners with qualified business income in excess of $2 million or $2.5 million, depending on filing status. Trusts cap out at $50,000 of qualified business income.
Reduction in Federal Estate and Gift Tax Exemption Amounts
Current law provides that the individual federal estate and gift tax exemption will be reduced to $5,000,000 (adjusted upwards each year for inflation) in 2026. The House Ways and Means Committee proposal accelerates this reduction, lowering the exemption amount to $6,020,000 (after the inflation adjustment), effective as of January 1, 2022. Federal estate and gift tax are assessed at a flat rate of 40%.
In addition to the federal estate and gift tax, the federal generation-skipping transfer (GST) tax, applicable for gifts to “skip persons”, is also assessed at a flat rate of 40%. If the federal estate and gift tax exemption is in fact reduced to $6,020,000 in 2022, the GST exemption will mirror that reduction.
The proposal would have a significant impact on grantor trusts – trusts in which, the individual who creates the trust, is the owner of the assets and property for income and estate tax purposes. According to the plan, if a taxpayer were to establish a grantor trust after the enactment date of legislation, the trust would be included in their gross estate. This subjects the trust assets to federal estate tax upon the grantor’s death.
Existing grantor trusts would be grandfathered, but with an important qualification: if a “contribution” is made after the legislation enactment date to an existing grantor trust, the portion attributable to the contribution would be subject to the new rules. Clear definition of what would be considered a “contribution” has not yet been offered. The most critical provisions applicable to grantor trusts are:
- Estate Tax Inclusion: Any grantor trust established or funded after the enactment date would be included in the grantor’s gross estate for federal estate tax purposes, valued at the grantor’s date of death.
- Gift Tax Consequences: Except for grantor trusts created and funded before the effective date, a distribution from a grantor trust to someone other than the grantor or the grantor’s spouse will be treated as a taxable gift from the grantor on the date of distribution.
- Termination of Grantor Trust Status: After the enactment date, termination of grantor trust status during the grantor’s lifetime will be treated as a taxable gift of the trust assets on the date of the change of status. The new rules should not apply to automatic termination of grantor trust status due to the grantor’s death.
- Sales or Exchanges Not Disregarded: Sales and exchanges between a grantor and a grantor trust will no longer be disregarded for income tax purposes and will result in the recognition of capital gains or losses.
- Irrevocable Life Insurance Trusts
- Grantor Retained Annuity Trusts
- Spousal Lifetime Access Trusts
- Qualified Personal Residence Trusts
Trusts and estates would be subject to a 3% surcharge on taxable income in excess of $100,000, as opposed to individuals who would only be subject to this surcharge once their taxable income exceeds $5,000,000.
Prohibition on Roth IRA Conversions
The proposal would prohibit individual taxpayers with taxable income over $400,000 and married taxpayers with taxable income over $450,000 from converting a traditional IRA (which is tax-deferred) to a Roth IRA (which is tax-exempt) as of January 1, 2032. These conversations are known as “backdoor conversions” and have long been a popular strategy used by high earners to maximize contributions to a Roth IRA.
Elimination of Valuation Discounts
The proposal would eliminate valuation discounts for lack of control and lack of marketability for minority interests of closely held entities made up of “non-business assets.” For example, passive assets held to produce income and not used in an active trade or business.
Qualified Small Business Stock Exclusion
Under current law, the qualified small business stock exclusion enables taxpayers to exclude 100%, and in some cases, 75%, of the gain realized from selling qualified small business stock that has been held for at least five years. The bill proposes to eliminate, for high earners, the 100% and 75% exclusions for sales of qualified stock acquired after February 17, 2009, and sold after September 13, 2021, unless the transaction was already subject to a binding contract. Instead, the 50% exclusion rules would apply which significantly reduces the tax benefits and incentives for entrepreneurs and small business investors owning qualified small business stock.
Excess Business Losses
Under current law, excess business losses for noncorporate taxpayers are limited to $500K for married filing jointly and $250K for individuals, indexed for inflation, and losses in excess of those limits may be carried forward. This law is set to expire in 2027, but the bill proposes to make this limitation permanent and change how losses may be carried forward.
Corporate Tax Rate
For corporations, the current federal tax rate is 21%. The bill proposes to change this to a graduated structure of 18% for taxable income below $400K, 21% on the taxable income amount from $400K to $5 million, and 26.5% on the taxable income amount in excess of $5 million.
S Corporation Conversion
For S corporations organized prior to May 13, 1996, the bill proposes to permit them to reorganize as partnerships in the two-year period beginning on December 31, 2021, without triggering a tax event. This may help S corporations that have amassed appreciated assets or would like the flexibility of a partnership structure.
For carried interest, the bill proposes to increase the holding period required to qualify for capital gain treatment from three years to five years. Taxpayers with an AGI less than $400K or who have income attributable to a real property trade or business could still use the three-year holding period.
Business Interest Deduction
The bill proposes to change the business interest deduction limitation so that it would be applied at the partner and shareholder level as opposed to at the entity level. Also, the bill proposes to limit the carryforward period for disallowed business interest to five taxable years for any disallowed interest beginning in 2022. Under current law the disallowed interest carries forward indefinitely.
Start Planning Now
The most effective tax planning is the planning that starts early. And when we’re facing a slew of proposed tax law changes, there’s even more reason to start tax planning as soon as possible. While nothing is set in stone yet, we can help start the dialogue and anticipate how these changes affect your specific scenario. Call us today to start your proactive 2021 tax planning.
Call us at (360) 734-4280 or fill out the form below and we'll contact you to discuss your specific situation.
Tanya Silves, CPA
Partner, Tax Director
Tanya Silves is a Partner and the firm’s Tax Director, with a deep expertise in tax planning and preparation for individuals and businesses.