President Biden and his administration have long indicated there would be a change coming to the way capital gains are taxed for individuals, decedents, and even noncorporate entities, such as trusts and partnerships. In April 2021, the president addressed the public with a speech and subsequent fact sheet outlining his proposed “American Families Plan.” The Treasury provided further detail and guidance into the matter through the release of its General Explanation of the Administration’s Fiscal Year 2022 Revenue Proposals (i.e., the “Green Book”) in May 2021. While no legislation has yet been passed, it is worth taking a moment to review the “What, When, and Why” of these significant, proposed changes.
In the American Families Plan (AFP), the Biden Administration is proposing an increased tax rate on capital gains and qualified dividends to equal the top ordinary income tax rate of 39.6% for households earning over $1 million (or $500,000 if married filing separately). Currently, the top ordinary rate for individuals is 37%, but the AFP also proposes a return to 39.6% for the top marginal tax rate for individuals. It should also be noted that the net investment income tax of 3.8% would be imposed in addition to the income tax, resulting in a tax rate of 43.4% on capital gains for high earners.
The Green Book does go further to offer a simple example as to the mechanics of this taxation for taxpayers near the noted thresholds. The example is as follows:
“A taxpayer with $900,000 in labor income and $200,000 in preferential capital income would have $100,000 of capital income taxed at the current preferential tax rate and $100,000 taxed at ordinary income tax rates.”
The Green Book also explains a new provision that would significantly expand the application of the Net Investment Income Tax (NIIT) and the Self-Employment Contributions Act (SECA) tax to earnings from pass-through entities. Briefly, all pass-through income of high-income taxpayers would be subject to either the NIIT or SECA tax, a departure from current law in which many pass-through owners could escape those taxes on that income. The definition of “net investment tax” would be expanded to include income from trades or businesses that is not already subject to employment taxes for taxpayers with AGI over $400,000. Further, the SECA tax rules would be revised such that many limited partners and LLC members – as well as S corporation owners – with material participation would be subject to SECA tax on their share of income exceeding certain thresholds.
Transfers by Gift or Death
It is worth mentioning a related proposal in the AFP ending the step up in basis at death for gains in excess of $1 million per person (or, $2.5 million per couple when including existing real estate exemptions). The Treasury Green Book provides further detail noting that transfer of appreciated property by gift or on death would cause the donor/decedent to realize capital gain at the time of transfer—except for transfers to a spouse or charity; gain on tangible personal property; transfers of family owned and operated businesses and farms to heirs who will continue operating these entities; and the above-mentioned exclusion of $1 million per person for property transferred by gift or at death.
It’s been speculated that this proposal for gift/death transfers will serve as a safeguard against the change in behavior caused by the new capital gain taxation for individuals. The Joint Committee on Taxation must consider the economic and investment impact of tax legislation, and a significant increase in the tax rate on capital gains may result in a decrease in sales/realization and a decrease in tax revenue. If there is no “relief” for holding appreciated property indefinitely and transferring at death, there may be an incentive for taxpayers to realize that gain now and, thus, pay taxes now.
One final note on changes to capital gains: the AFP and Green Book also note that noncorporate entities (like partnerships and trusts) would be required to recognize gain on unrealized appreciation of property held without a recognition event in the past 90 years.
No effective date for the change in capital gain tax rates for individuals was mentioned on the campaign trail or in President Biden’s American Families Plan speech or fact sheet, but the Green Book notes an effective date of April 2021, or the date of announcement. Several explanations for the use of a retroactive date over a prospective have been speculated, including decreasing the likelihood of a ‘run on the market’ to offload appreciated property before the new tax rates take effect.
Some commentators suggest that a more likely scenario is that any increase in the capital gain tax rate will become effective on the date the bill is introduced or passed. This timing suggests there may be a window to recognize embedded gains at current rates before a potential increase in rates.
Transfers by Gift or Death
The Green Book notes that gains on property transferred by gift or death would be recognized for transfers occurring after December 31, 2021.
Finally, gain on unrealized appreciation of property held in noncorporate entities without a recognition event in the past 90 years would begin December 31, 2030 (i.e., the testing period would begin January 31, 1940).
According to the Biden Administration, the overall goal of these changes in capital gains taxation is to equalize capital gain and ordinary income tax rates for high earners, thereby eliminating tax benefits that have historically and disproportionately favored high net worth individuals.
While the Treasury Green Book attached further detail to the changes proposed in the American Families Plan, there still is no thorough, technical guidance available. These proposed changes—rate increases, thresholds, effective dates, etc.—are just that, proposed, and are subject to modification in Congress. Time will reveal the outcome, and as always, we will keep you informed.
We can assist with questions and planning for these proposed changes to taxation of capital gains. Please reach out to your primary Elliott Davis point of contact or a member of the Personal Financial Services team here.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.
The American Families Plan Fact Sheet, Biden Administration
General Explanation of the Administration’s Fiscal Year 2022 Revenue Proposals, US Dept of the Treasury
BTAX OnPoint: Treasury Green Book, Bloomberg Tax & Accounting
Biden’s Capital Gains Proposal: Effective Date Considerations, KPMG Catching Up on Capitol Hill Podcast Episode 13-2021