During his campaign, President-elect Biden proposed sweeping tax law changes, some of which could significantly alter the tax landscape for alternative investment funds and individual investors. With this in mind, alternative investment funds have several short-term tax planning issues to consider. Whether or not Biden’s tax agenda can be brought to full or partial fruition depends greatly on whether Democrats can take control of the Senate. Two Senate races in Georgia will occur in January, so it is not possible to predict whether Democrats will control both Houses of Congress prior to year’s end, which serves to make tax planning much more difficult.
Some of the more significant changes which Biden has proposed include:
- Moving the top income tax rate from 37% to 39.6% for individuals earning over $400,000.
- Taxing long term capital gains (LTCG) and qualified dividends at ordinary rates for persons with income above $1,000,000, thereby removing the favorable tax rate treatment currently received. This could subject many investors to significantly increased taxes as LTCG have a current maximum tax rate of 20%, plus a potential Net Investment Income Tax of another 3.8%. Higher bracket individuals could see taxes on LTCG increase by 15.8%.
- Eliminating the social security tax cap on income over $400,000. Currently, social security tax is paid at a rate of 6.2% by the employee and 6.2% by the employer on earnings up to $137,700. This puts the maximum social security tax per employee at a total of $17,074, split between employer and employee. Self-employed individuals pay the entire 12.4% but can deduct half of it as a business expense on their income taxes. Under the Biden plan, once $400,000 is reached, the tax would kick in again. This essentially creates a gap between $137,700 and $400,000 where there would be no additional tax. Once the $400,000 threshold is reached, however, there would be no cap. This means that both individuals with high earnings and employers with high earning employees could see a significant increase in social security tax.
- Phasing out the 199A pass through deduction for taxpayers with incomes of over $400,000.
With the uncertainty around control of Congress not resolving until after year’s end, investors and alternative investment funds do have some possible short-term planning strategies. Accelerating LTCG recognition to 2020 is most obvious. Managers and investors may wish to sell appreciated securities in 2020, meaning they will pay the tax when the favorable rates are guaranteed. Since wash sale rules don’t apply to gains, securities sold and then quickly repurchased would still allow recognition in 2020. There is always a chance that market prices could shift between sale and repurchase.
An additional strategy, especially for securities with significant appreciation, is to hedge against them and create a constructive sale. Under Section 1259 of the Internal Revenue Code, a constructive sale occurs when an investor enters a position which essentially offsets the appreciated position and effectively locks in gains. Prior to the enactment of the Constructive Sale Rules, this was a common tactic employed by hedge funds to ensure LTCG treatment on appreciated positions which had been held under one year, among other reasons. Examples of transactions that trigger constructive sales include “shorting against the box”, whereby a short sale is made against a similar or identical position or the use of offsetting futures or forwards contracts. If such a position is opened, capital gain recognition on the appreciated securities is required at the time the offsetting position is taken.
Nonetheless, there are exceptions to the Constructive Sale Rules which investors may wish to take advantage of. For example, if the offsetting position is closed within 30 days of year’s end, there is no recognition requirement. Investors who have large, appreciated positions that they cannot or do not wish to sell might open a short position at year’s end, wait and see the outcome of the January 5th runoff elections, and then determine whether to close the offsetting position or hold the position and force a constructive sale recognition in 2020.
Additionally, investors with depreciated securities they are planning to sell in 2020 in order to offset gains could potentially use wash sale rules to move these losses into 2021, when they might be more valuable against gains that have a higher tax rate. Wash sales occur when securities with a loss are sold and then the same or substantially the same securities are repurchased within 30 days before or after the sale. If a wash sale occurs, the resulting loss is merely factored into the basis of the new positions purchased and no loss is recognized.
Investors who will have positions with significant recognized LTCG in 2020 and positions with large unrealized losses may wish to sell those loss positions to offset the gains. If additional LTCG are expected in 2021, investors may wish to hold onto loss positions and take them in 2021 when LTCG rates might be higher with a Democratic administration. One strategy that investors could employ is to sell securities near year’s end. Then, if Democrats do control the Senate, repurchase them in January triggering the wash sale limitation. The securities could then be disposed of shortly after, which would cause the loss recognition to move forward to 2021 when such losses might be more valuable.
The possibility of an increase in self-employment tax is perhaps one of the most likely of Biden’s proposals to be enacted. Social security is underfunded and targeting wealthy earners is a way of closing the gap. Fund management companies, if possible, may wish to accelerate the payment of management fees where possible in order to recognize them in 2020 where lower top tax rates apply and where the social security portion of SE tax is guaranteed to be capped. Additionally, management companies which pay salaries to their employees may wish to pay additional bonuses in 2020 and lower 2021 pay rates in order to ensure more favorable treatment, especially if they have ready access to the necessary cash.
At this point in time, investors are left with uncertainty about tax planning. Some of these strategies can be complicated and investors should consult with knowledgeable tax professionals.
We can help
Elliott Davis’s Alternative Investment Funds Team is ready to assist organizations with year end tax planning in light of potential changes to come. For more information, contact one of our professionals today.
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.