Analysis of Biden's New Tax Proposal
Video Transcript:
Hello friends. I'm Mike Hengehold. Today, I'm going to discuss the tax changes that are coming down the pike for us. You'll recall that the stimulus programs related to COVID generated a lot of spending, and the government is now talking about an infrastructure program that could be upwards of $ 2 trillion.
So, this is going to create quite a shortfall in revenue, and the administration's answer is partially to increase taxes. So, what I want to do is talk about the changes that are most likely to affect HCM clients and HG CPA's clients. Now the most likely effective date for this tax act in terms of when the taxes will start to be levied is January the 1st of 2022. Obviously, the legislation will go through negotiation and be developed throughout the course of this year, and we'll obviously keep you posted as that happens. But what that means that we have all of 2021 to prepare from a planning perspective. It seems like a long time, but that's really only a little over eight months. And some of these taxes, as you'll see in a minute, can be significant and may require some pretty heavy lifting to get ready.
So the first tax that's going to kick in is going to be an additional Social Security tax. This will be a 12.4% tax, and it'll be levied on people who make more than $ 400,000. Remember the government wants to raise taxes, both on businesses and higher income individuals, and they've picked that $ 400,000 threshold as the level that they want to impose additional taxes on for individuals. I don't always respect it, but that's the working goal. So, this Social Security tax applies to people who have earned income, so wages or income from business, that exceeds $ 400,000. And that creates a gap, or a donut hole, between the current $137,000 cutoff and this new tax. Like Social Security, the tax would be shared equally between employers and employees.
But remember that, if you own the business, you are responsible for both halves of the tax. So, you still owe the 12.4% tax, you just have to pick up both pieces of it. And what this highlights is why something like sub-S status is attractive and you would want to avoid being recognized as either a sole proprietor or a disregarded entity, which would be like a single member LLC, something like that.
A second tax that I think is particularly unfair, and I'll explain why, it's a sneaky reimposition of the estate tax. Now, this comes through eliminating the step-up in basis that inheritors receive when they inherit property. So, for example, if your parents were to pass away and you inherited their home, or you inherited a few shares of stock that they'd owned for a long time and had appreciated, the way the rules work now is you inherit that and it's a tax-free receipt.
The reason it's unfair is because a lot of these gains are related to inflation. In other words, there has been no real economic gain. Yet, the way these changes will work would be to effectively tax that inflation as though it was a real profit. I think that's a bad idea. Hopefully there'll be some adjustment for inflation that's occurred over the years if they do eliminate the step-up in basis.
Another change is going to involve increasing the tax brackets. So right now, the highest tax bracket is 37% for people who make about $620,000 and change for a couple. What's going to happen is that tax rates going to go up to 39.6%. But at the same time, they're going to lower the threshold where it kicks in, so it's a double whammy. They're going to lower it back to that $ 400,000 threshold, and right now, people at that income level are paying 35%. So it's not really an increase from 37% to 39.6%. For many people, it's going to be increased from 35%. So, it's a much bigger increase than is being advertised when you dig into the details.
Another tax increase, and this one I really don't like, and when I said I don't like them. It's because I don't think they're fair and out. Let me explain why. The government wants to double the capital gains tax from 20% to almost 40%. It would be that 39.6%, that top individual rate that they want to impose on people who have incomes of more than a million dollars. Now don't zone out on me just yet, because I know you hear that you think, well, I'm never going to have income of a million dollars and I don't know anybody that's going to have that level of income. The reason this is unfair is, if you think of this from the perspective of someone who has been saving for their retirement, a business owner, who has all of their worldly wealth tied up in their business, and they've been planning and building their business for the last 30 or 40 years, and now they need to sell it, they need to monetize that asset in order to retire. And the same thing is true for corporate employees who are planning to take advantage of the Net Unrealized Appreciation option, where they're going to be getting employer stock. So, any appreciated asset is going to create this problem.
So, remember this would be around a lifetime event, which is why the income could spike. So if you sold your business, let's just use a little back of the envelope, math here: if you sold your business for $ 3 million, the tax on that under these new rules could be a million bucks. Under the old rules, it would have been more like $600,000. So your taxes would be $ 400,000 more.
What that means is that you'll have to work several more years in order to create the extra income to make up for that shortfall that you may have planned very carefully for over the last decade. To have somebody’s retirement impacted this heavily by the simple stroke of a politician's pen is unfair.
And I also think it's unfair for another reason. And this goes back to the same thing I was talking about with the step-up in basis, and that is inflation. When we talk about capital gains, a lot of the gains that we see aren't really economic gains. The reality is that inflation has driven the price of things up. So that should not be taxed. At least it shouldn't be taxed at ordinary income rates. Remember that the whole idea here of these lower rates is to recognize two things. One is that inflation takes away some of the economic profit, therefore that lower tax rate is fair. The other thing, when it comes to qualified dividends is that the company, the corporation that paid the dividend, has already paid tax at its highest marginal rate.
So there are already two taxes in play if they increase the taxes here, which basically then also taxes inflation, you're basically paying three taxes on this type of income, which again, strikes me as being unfair. Hopefully they'll sort that out before legislation is finalized.
Another way that small businesses are seeing their taxes go up is through the elimination of the Qualified Business Income Deduction. This was something that was put into place to equalize the tax on pass-through companies versus corporations. It was a very good idea. And now they're starting to whittle away at this in order to raise revenue.
Another way that will affect people is by reducing the tax benefit of itemized deductions. So, one of the things that will likely come back into play as what are referred to as the old Trump Tax Cuts are phased out, is itemized deductions are likely to come back and be more relevant. Well, these proposed tax changes whittle away at the tax benefit of those deductions so that you don't get the full impact of them. In other words, you're going to be paying tax at a higher rate, and getting the benefit of the deductions at a lower rate.
Finally, the big one to mention is the rolling back to the old days of the Estate and Gift Tax rules. So right now, people have to have a pretty significant estate, an individual has to have more than $ 11 million, in order to owe estate tax. What the administration would like to do is roll that back to the 2009 thresholds, which would have only been three and a half million dollars. Again, this would be on fair market value, so that's part of it. They also want to reimpose the tax rates that were in play then, which were higher tax rates. And remember, this is in conjunction with eliminating the step-up in basis. So, there's a lot of ways here that the tax on wealth transfers would be going higher.
Well, that does it for today. Those are the biggies. Again, all I wanted to do was outline them. We'll be coming back with more information about how to prepare for these. If any of these issues feel like they hit home for you, or if you have any questions, obviously feel free to reach out to us, contact your advisor, and they can set up a meeting with our tax planning team to go through, in more detail, how you how you might get ready for these things.
Thanks everybody for watching. I appreciate it.