The current federal estate tax exemption is $11.7 million per person. (It's much less in some states, like the $1 million threshold in Massachusetts).
They say nothing is certain in life but death and taxes. It feels like one other certainty is that taxes are going to increase. Business owners should feel like there is an "X" on their back. Let's highlight some of the problems to bring us one step closer to a solution.
In 2010, when the Democrats had the White House, the House of Representatives and the Senate, the Affordable Care Act became law. In 2017, the Republicans had all three, and the Tax Cut and Jobs Act passed. In 2020, the Republicans only had the White House and the Senate, but they still were able to pass the CARES Act. This year, the Democrats again have the White House and both chambers of Congress, and the American Rescue Plan Act became law March 11, 2021.
Next on the agenda are the American Jobs Plan and the American Families Plan. These are big plans tied to the "Build Back Better" agenda of the Biden administration. There are proposed tax changes that are relevant to businesses and highly compensated C-suite management.
I applaud the $80 billion funding request to ensure that the IRS has the resources it needs to enforce tax laws against businesses. This proposal includes updating computer hardware and software that is decades old. That means more agents doing more audits more efficiently.
The government wants to pay for these bills by closing the "tax gap." The tax gap is the amount between what is paid to the U.S. Treasury and how much is owed in taxes.
The IRS is going to come down hard on businesses, scrutinizing some of those gray-area deductions. You've got to find ways to reduce taxes in other ways.
Perhaps you should accelerate income in 2021 and maybe push off expenses in 2022. Paying more for this year could mean paying less for 2022. When should you recognize revenue if bonus depreciation is eliminated and stacked in later years? The C-corporation tax rate is slated to rise from 21 percent to 28 percent. What's the best entity structure to minimize higher taxes in 2022 and beyond?
The maximum capital gains rate could rise from 23.8 percent to 39.6 percent for adjusted gross income above $1 million. For many business owners, the only year they will make $1 million is when they sell their business. That's the year they turn an illiquid asset (their business) into a liquid asset (a retirement portfolio).
The change would be effective retroactively as of April 28, 2021, so, you can't rush to make a sale now. Instead, the government put a gun to your head and said, "Keep working; you can't retire yet …" Fortunately, there has been some relenting on this massive hike.
Small-business owners will be hurt by the estate tax basis "step-up" rule change. For decades, the rule has been that when a small-business owner passes away, their assets are revalued at the date of their death. That revaluation determines the cost basis of the company when it gets distributed to beneficiaries.
For example, let's say that Wayne, the sole owner of a family-run lumberyard in Holyoke, passes away. The company is valued at $12 million. Previously, if Wayne died, he could have passed ownership to each of his three children at a cost basis of $4 million each (3 children x $4 million cost basis = $12 million value). Theoretically, because of the step-up rule, the kids could have turned around and sold the business with no tax implication because the cost basis equaled the value.
Under the proposed change, their $4 million shares would have a cost basis of zero. At the new 39.6 percent capital gains rate, how are each of these kids going to come up with the cash to pay their $1.6 million tax bill? The government is forcing the kids to liquidate the business just to pay taxes. Possible solutions are installment sales, tactical gifting, insurance (which can be expensive) and strategic cost averaging.
The current federal estate tax exemption is $11.7 million per person. (It's much less in some states, like the $1 million threshold in Massachusetts). The proposal is to cut it down to $6 million. Further, Grantor Trusts are at risk. Grantor Trusts allow business owners to create a trust separate from their estate. The proposed change is that new trusts would be part of the estate; currently, there appears to be a grandfather clause.
Valuation discount planning (VDP) is at risk. VDP allows business owners and investors to take an asset in a partnership and gift it out to family in pieces. Each piece gets discounted by up to one-third for tax purposes because it's worth less as a noncontrolling stake.
Under VDP, Wayne could give his $12 million lumber company to his three children. The kids' share would only be worth a bit more than $1 million each, saving them hundreds of thousands of dollars in taxes.
Many business owners are taxed at the top federal income rate. The maximum rate is proposed to rise from 37 percent to 39.6 percent. An extra 2.96 percent points might not sound like that much, but you also get there quicker. The threshold would lower from $518,401 (married, filing jointly, or MFJ) to $409,000 (MFJ). Will federal tax laws change so much for your company that maybe now it makes sense to consider changing your state residency?
So, how do you get your AGI under the $409,000 threshold? You could accelerate income this year by converting traditional individual retirement accounts to Roth IRAs or take bonuses early. There is a list of options in the May 8 Mind Your Business column, "Are taxes killing your business."
You could defer income for four to eight years. Take a big bonus in 2021 and invest it. You'll pay taxes at the 2021 rates, draw from this income portfolio until a new White House possibly lowers taxes, then go back to drawing a salary. An ounce of planning can save you a ton in taxes.
Allen Harris is the owner of Berkshire Money Management in Dalton. He can be reached at [email protected].