Many investors are wondering what the implications are if voters place a Democrat in the White House and what it could mean if the House and Senate obtain a Democratic majority.
There are many changes that may come about should the above scenario come to fruition. However, before we begin, I’d like to note that we are not trying to make a determination about which set of tax laws are best. Since the current tax laws are already in place, we will be setting out to answer questions relating to the changes the proposed tax laws may enact. More specifically, we will focus on how these changes may affect your portfolio, your income tax liability, and your estate tax liability. Let us take a look at the changes you may see in each of these areas.
Effects on Your Portfolio
In 2017, corporate tax rates were cut from 35% down to 21%. Former Vice President Biden is targeting an increased corporate tax rate of 28%. In addition, his proposal would create a minimum tax of 15% on corporations with book profits of $100 million or higher. Currently, a company may have net profits, but after deducting the cost of investments, R&D expenses, etc., they pay very little or even no federal income tax. This “minimum book tax” is not in addition to the corporate tax rate. Rather, it is a minimum tax on profits.
Another law that came about through the Tax Cuts and Jobs Act (TCJA) is the Global Intangible Low Tax Income (GILTI). This new tax places a minimum 10.5% tax on foreign income contributed to intangible assets such as copyrights, patents, and intellectual property. Though many agree that the law isn’t fully working as intended, it was developed to deter companies from shifting these types of assets overseas where they may pay little to no tax on the income they generate. In Biden’s proposal, GILTI tax rates would double to 21%.
Should we see an increase in corporate tax rates, this would directly impact earnings. With a “book tax,” companies that fully expense investment costs or that receive R&D credits to lower their tax liability would now be subject to a minimum tax. In addition, many of the largest US companies listed on the S&P 500 derive half or more of their business from overseas markets. This, too, could mean a decrease in earnings as their tax liability increases. As these companies cope with additional taxation, there is the potential for their stock prices to weaken.
Effects on your income tax liability
Biden’s proposed tax plan comes with various changes, mostly to high income earners. His proposal shifts the marginal tax rate on the highest income filers from 37% to 39.6%. Long term capital gains and qualified dividends for those with gross income over $1 million would be taxed at the ordinary rate of 39.6%, which is nearly double the current highest rate of 20%. Anyone with income over $400,000 would be subject to a new Old-Age, Survivors, and Disability Insurance (Social Security) payroll tax –12.4% split equally between employee and employer. Business owners of pass-through entities earning more than $400,000 would lose their Qualified Business Income (QBI) deduction.
Some other changes include restoring the Pease limitation and capping itemized deductions to 28% of value, introducing renewable energy tax credits to individuals, expanding child and dependent care credits to $8,000 per child/dependent up to $16,000, and overhauling the deductibility of retirement plan contributions. This last change would provide a flat 26% refundable credit for every dollar contributed to a traditional retirement account (such as a 401(k), 403(b), IRA, or SIMPLE IRA) up to the maximum contribution amounts. The credit would be refunded directly to the retirement account. Since the credit is a flat percentage, those in higher tax brackets receive less benefit.
There are plenty of uncertain details around the proposed changes. One is the ordinary income taxation of long-term capital gains. What type of assets would be included in this new rule? Would a business owner who is selling her closely held business be required to pay ordinary income rates on all the proceeds? What about the sale of assets used in a trade or business or the sale of real estate that has been depreciated under current allowances? As always, we will have to wait to see how some of these questions are addressed.
Effects on your estate Tax liability
There are a couple of key changes that have support from the Democratic party that are almost certain to make their way into discussions should we see a Democratic majority.
First on the list is a reversion of federal estate tax exemptions to their pre-TCJA levels (around $5.5 million) or even to their pre-American Taxpayer Relief Act (ATRA) levels (around $3.5 million). This is a very stark contrast to the current $11.58 million exemption currently in place.
Next is the removal of the step-up in basis for assets passed to heirs upon death. Currently, when an owner dies and leaves the asset to the heir, the owner’s cost basis “steps up” to the current market value of the asset. The heir could then sell the asset and pay little to no capital gains tax. Without a step-up in basis, it would likely make it much more burdensome on the heir to prove the original cost basis for inherited assets. If the owner kept exceptional documentation while living, it may be okay. If not, be prepared for headaches.
Further, if the step-up in basis was eliminated and the estate tax exemption was lowered to its previous level, it could mean adding additional capital gains tax to an already high estate tax rate of 40%. The amount of wealth transferred to heirs may not be as high as expected.
What does it all mean?
Whenever there is change, there are always opportunities. When it comes to your investments, consider realizing some of your positions with low cost basis or even donating them to a charity. Use previous losses to offset the gains to the extent you can. Be prepared for the next shift in pricing. It may or may not come right away, but if you are sticking to your allocation and maintain your focus, you’ll weather the storm. In your estate, consider making gifts of assets to your children or heirs that are in lower tax brackets to remove the assets from your estate and avoid the higher tax liability. Think about utilizing life insurance to replace wealth lost to taxes or donated to charity.
In the end, regardless of the political atmosphere, we will press on. Don’t worry. You can have peace of mind knowing we are here to help guide you through your decisions.