What If Biden’s Capital Gains Tax Is Retroactive?

Get Morningstar’s essential reading for financial professionals in Advisor Digest.

Stop hyperventilating.
These are just proposals.
Don’t worry just yet. 

These were some of the most common refrains heard around President Biden’s proposals to raise taxes to help pay for infrastructure and social spending.

In most cases, I would agree. But this time is different. I’ll explain why and what to do about it in this column.

Some of the greatest hand-wringing came around Biden’s planned huge bump in the capital gains rate for high income taxpayers.

It is true that we don’t know what will make it into law. However, the fine print of what has already been proposed could mean that when it comes to capital gains taxes, the effective date after which these increases would be in force has already passed.

So, what can advisors do? One option is to put your head in the sand, hoping the proposals don’t pass. Clearly, there’s a chance of that. But what if they pass?

In my opinion, planning is essential, but you have to walk a fine line: Make moves than can protect your clients in the event the new laws are enacted, as long as they will not be harmed should the laws not pass. 

The Basics

For taxpayers with income of over $1 million, long-term capital gains will be taxed at ordinary rates. The top rate for 2021 is 37%, plus the Medicare surtax of 3.8% (plus state tax). Under the proposals, the top rate will be 39.6% in 2022 (plus the surtax). Considering that the current top rate for long-term capital gains is 20%, the new rules almost double that.

Critically, the Treasury Department said “This proposal would be effective for gains required to be recognized after the date of announcement.” While that date isn’t specified, the American Rescue Plan was announced on April 28, and the administrations “Green Book” of proposals was published May 28. Take your pick.

This potential retroactive tax can impact four categories of high-income clients:

• Those with large sales in 2020
• Those with large sales prior to publication date in 2021
• Those with large sales after publication date in 2021
• Those anticipating large sales

What planning strategies can apply that will not harm clients in the event these proposals don’t become law? I’ll cover some ideas as follows. 

Large Sales in 2020

At first, you might think this was a mistake to bring up large sales from 2020. It’s not–if the sale was an installment sale. Let’s say your client sold a zero-basis business on July 1, 2020, for $10 million, getting $4 million down and payments of $2 million each year from July 2021 through July 2023. Assuming your client regularly has income in excess of $1 million, they likely reported (or will report on an extended return) the sale on the installment method. Thus, the capital gains tax (excluding the surtax) for 2020 would be $800,000 (20% times $4 million). With no tax law changes, your client would expect capital gains tax of $400,000 per year for the next three years. 

Should the proposals become law, your client will now pay federal capital gains tax of $740,000 in 2021 and $792,000 in 2022 and 2023. This is a total of $1,124,000 additional tax! 

Although it means more cash up-front, your client might be better off electing out of the installment-sale method. In that case, your client would pay tax on the entire $10 million, $2 million, and all due with the 2020 tax return. 

To elect out of the installment method for 2020, the election must be made by Oct. 15, 2021–either on an extended, original return, or an amended return, if the return has already been filed. 

The clock is ticking … Will we know if the new law will pass before Oct. 15? Who knows? But it is your job to give your client the choice. 

Large Sales Prior to Publication Date in 2021

This is an interesting situation, because the strategy above could apply here as well. Sales occurring prior to publication date would not be subject to the higher capital gains rate. Thus, electing out of installment-sale treatment could be advantageous. And, because this election can be made as late as Oct. 15, 2022, we would almost assuredly know what was enacted before taking the leap. 

Large Sales After Publication Date in 2021

Although sales after the publication date could potentially be subject to higher rates, 2021 is not over, so it might still be possible to lower taxable income below $1 million. It is important to note that should income be below $1 million without capital gains, to the extent the gains recognized do not push income over $1 million, it will not be subject to the higher rate–only the amount over $1 million will be taxed at ordinary rates. 

How can a taxpayer lower income? Utilizing standard tax planning can useful here. Strategies to be considered should include charitable giving, income deferral, loss harvesting, business equipment purchases, and deductible expenses.

Those Anticipating Large Sales

Key planning for those anticipating large sales is to keep income below $1 million.  Beside general planning techniques to reduce overall taxable income, it might be possible to lower gains by structuring installment sales and/or charitable giving.

Let’s use an example similar to the first situation. Your client is selling a zero-basis company for $10 million and has other taxable income of approximately $500,000.  Absent planning, should all be taxed in 2021, the capital gains tax would be $3,615,000 ($500,000 times 20% plus $9,500,000 times 37%). 

Let’s say that the deal can be structured to receive $5 million down and $1 million a year for five more years. Since your client has charitable inclinations, they set up a donor-advised fund with $1.5 million of stock (15% of the total shares). Assuming that $1.5 million of the down payment is allocated to buy out the donor-advised fund, your client would report $4 million of income ($3.5 million plus $500,000) while deducting $1.2 million of charitable contributions (due to percentage limitations, $300,000 would carry over to 2022). Because the contributions offset ordinary income, first-year tax on capital gains would be approximately $766,000 ($500,000 x 20% plus $1,800,000 x 37%). The 2022 tax would be $179,200 ($500,000 x 20% plus $200,000 x 39.6%), while the following four years would result in tax of $298,000 per year ($500,000 x 20% plus $500,000 x 39.6%). 

This total tax is $2,137,200, leaving net proceeds of $6,362,800 and a donor-advised fund of $1,500,000. This amount of net proceeds is almost identical to the “no planning” example, which leaves net proceeds of $6,385,000, but also provides a fund for future charitable giving of $1,500,000. 

Without the donor-advised fund but with the transaction structured as an installment sale (like above), the first-year tax would be $1,765,000 ($500,000 x 20% plus $4,500,000 x 37%), while the following five years would incur tax of $298,000 per year ($500,000 x 20% plus $500,000 x 39.6%). This total tax of $3,255,000 is lower than the “no planning” tax by $360,000.

Finally, if your client has charitable inclinations and also wants additional cash flow, a charitable remainder trust can be considered. It is important to note that the charitable remainder trust strategy is best implemented in 2021. This is because the “tax on transfer” rules are slated to become effective in 2022. Thus, the gain attributable to the income stream would be taxed.

Conclusion

Even though Biden’s tax proposals are not certain to become law, the retroactive effective date of some of the provisions make planning essential. Consider strategies that will not be disadvantageous should the proposals not be enacted. 

Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and founder of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively work in the advisory business. Morningstar acquired her Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar or of Rowling & Associates LLC.