Source: BDO
Published: November 2020
Although vote counting continues and
legal challenges to the election endure, many news media organizations are
projecting that former Vice President Joe Biden will become the 46th President
of the United States on January 20, 2021.
The House of Representatives will remain under
Democratic control, but control of the Senate is somewhat less certain since
the balance of power will be determined in January 2021 following a run-off
election for two open Senate seats in Georgia. The run-off is necessary because
neither of the candidates in either of the races obtained more than 50% of the
total vote count as required by the state’s election law. A win by the two
Democratic candidates would shift the balance of power in the Senate from one
of GOP control to one where neither party has a majority. In that case, if all
Senators vote along party lines (including independent senators who typically
vote with Democrats), any deadlock on legislation would be broken by Vice
President-elect Harris casting the deciding vote. This tiebreaking potential
would also determine the Senate leadership, the ratio of committee memberships
between the parties and the leadership of each committee.
Under a Biden administration and if the Democrats assume control of
both the House and the Senate, taxpayers are likely to
see increases to the corporate tax rate and to the top tax rate for
individuals. However, should the Republicans retain control of the Senate, it
would be difficult to effect any tax rate changes and most provisions in the
Tax Cuts and Jobs Act (TCJA) (as passed during the Trump administration) would
continue until they generally expire after 2025.[1]
What does this mean for taxpayers planning for year-end?
Assuming taxable income is consistent from year to year, but tax rates are expected to increase, a taxpayer may wish to accelerate income and defer deductions to higher income tax rate years. Assuming the same, but with a constant or declining income tax rate, then taxpayers may wish to take the tried-and-true approach to year-end tax planning by accelerating deductions and deferring income.
President-elect Biden has indicated that he would like to see the reduction or elimination of the tax cuts made by the TCJA. He believes that the tax system should be changed to ensure that large corporations and high-net-worth individuals pay their "fair share” of taxes. For individuals, President-elect Biden has proposed increasing the top income tax rates and expanding the Social Security tax base, as well as curtailing or eliminating various incentives that are currently available to high income taxpayers. If these plans are implemented, roughly $4 trillion would be raised over the next 10 years, as reflected in estimates obtainable through the Tax Policy Center and the Tax Foundation. The additional tax revenue would be used to pay for spending initiatives to improve the nation’s infrastructure, developing alternative energy sources and building up the U.S. manufacturing sector.
To be successful in implementing proposed changes, the timing of any future tax increases will be balanced against the need to keep the economy strong and resilient at a time when the country is trying to address the economic slump that was brought about by the coronavirus pandemic.
Despite all of the uncertainty, significant tax law changes are possible over the next few years, so it is important for taxpayers to understand both current tax law and changes that may be on the horizon. The following summarizes President-elect Biden’s planned initiatives for both corporate and individual income taxes, Social Security and Medicare taxes and the estate tax, as well as various tax incentives.
Individual Income Tax Rates
Current law provides for a progressive
income tax rate system, which means that tax rates increase as taxable income
increases. Under the seven-bracket system, tax rates for ordinary income start
at 10% and increase to 37% for taxable income of $622,050 for individuals
filing joint income tax returns in 2020, and $518,400 for individuals filing as
single taxpayers.
Under President-elect Biden’s plan, the TCJA tax
cuts likely would be repealed and the top federal income tax rate of 39.6%
would be reinstated.
Capital Gains and Qualified Dividend Income
Under current law, individuals are
subject to progressive income tax rates on capital gains and qualified dividend
income. The long-term capital gains rates are 0%, 15% or 20%, depending on a
taxpayer’s ordinary income tax bracket. Moreover, a net investment income tax
(enacted during the Obama administration) is imposed on high income taxpayers at
a rate of 3.8%, which brings the total maximum tax rate on long-term capital
gains up to 23.8%.
Under President-elect Biden’s tax plan, the tax
rate on capital gains would increase to 39.6% for taxpayers with taxable income
of $1 million or more, plus the 3.8% net investment income tax. As a result,
taxpayers whose taxable income exceeds $1 million would be subject to an
effective tax rate of 43.4%.
Business Income from Pass Through Entities (Partnerships, S Corporations and Sole Proprietorships)
Under current tax law, many businesses
qualify for a qualified business income deduction of up to 20%, which can lower
the effective tax rate on the business income of individuals from a high of 37%
to as low as 29.6% for qualifying businesses.
President-elect Biden would phase out the tax
benefits associated with the qualified business income deduction for
individuals making more than $400,000 a year, thus effectively raising the
business income tax rate from 29.6% to 39.6%.
Corporate Tax
The TCJA reduced the corporate income
tax rate to a flat 21% rate from a progressive rate of up to 35% before 2018
and abolished the corporate alternative minimum tax.
President-elect Biden would raise the corporate
tax rate from 21% to 28%, a middle ground between the top rate of 35% under the
Obama administration and the current 21% rate. He also would put in place a new
form of corporate alternative minimum tax that essentially would require
corporations to pay the greater of their regular corporate income tax or a new
15% minimum tax on worldwide book income.
Payroll Taxes
A 6.2% Social Security tax and a 1.45%
Medicare tax currently are imposed on both the employer and the employee. While
the wage base for the Medicare tax is unlimited, there is a cap on the Social
Security tax base equal to the first $137,700 of employee wages (increasing to
$142,800 for 2021).
In addition to the Medicare tax rate, which
totals 2.9% for the employer and the employee, an additional 0.9% Medicare tax
is levied on employees with wage and self-employment income above the same
thresholds that are applicable in the case of the net investment income tax
($250,000 or more for joint returns or a surviving spouse, $125,000 or more for
a married taxpayer filing a separate return and $200,000 in all other cases).
This effectively increases the collective employer/employee rate or
self-employed rate to 3.8% (1.45% twice + 0.9%), which would raise the Social
Security and Medicare tax rate for self-employed individuals to 16.2% (12.4% +
3.8%).
President-elect Biden has indicated that he
would remove the cap on the wage base for the Social Security tax for high
earners, defined as those making more than $400,000. These changes to the
Social Security and Medicare taxes would apply to employees and self-employed
individuals that have sole proprietorships or are partners in a partnership.
It is uncertain whether wages between $142,800
and $400,000 would be subject to the additional income tax, or whether there
would be a so-called “donut hole” before the higher rate kicks in for
individuals with taxable earnings in excess of $400,000. This would raise the
overall income tax rate on some businesses to as high as 55.8% (39.6% + 16.2%)
before taking into account state income taxes.
Estate Tax
The estate tax rate currently is subject to a progressive rate scale up to 40%. The estate tax is imposed upon the death of a taxpayer after an exemption allowance of up to $10 million per taxpayer, as indexed for inflation (currently $11,580,000 per taxpayer ($23,160,000 per married couple for 2020)). In addition, beneficiaries are entitled to a step-up in the tax basis of all inherited assets based on the date of death valuation or the alternative valuation date.
President-elect Biden would reduce the exemption amount to pre-Obama levels of $3.5 million per taxpayer, while increasing the top estate tax rate to 45%. He has also suggested eliminating the regime that allows for a step-up in tax basis on the date of death or alternative valuation date.
Investments into Distressed Areas
The TCJA introduced significant incentives for investments in qualified opportunity zones (QOZs). These rules allow taxpayers to defer recognition of capital gains where the proceeds are reinvested in a property directly or a QOZ fund property within 180 days.
The capital gains deferral exists until the earlier of the time the QOZ property is sold or December 31, 2026. In addition to the deferral, there is a 10% tax reduction if the fund is held for five or more years, a 15% reduction in tax if the property is held for seven or more years, and if the investment is held for 10 or more years, the appreciation of the QOZ fund investment (not the original gain but the post-acquisition gain) qualifies for a step-up in tax basis, essentially excluding the appreciation from gross income.
In addition to QOZs, a new markets tax credit is available to investors that inject capital into community development entities. The credits are progressive and vest with each year of expenditures and can equal up to 39% of the cost of the new markets tax credit project.
President-elect Biden has indicated that he would like to continue both programs and may be willing to expand and make the new markets tax credit program permanent.
Manufacturing and Business Incentives
Tax incentives currently are available for low-income housing, reducing fossil fuels and using alternative energy, as well as employer incentives for hiring individuals that qualify for the work opportunity tax credit and for hiring individuals with disabilities. Tax credits also are available to employers for providing child-care facilities on their premises so that working parents can continue working.
President-elect Biden supports these programs but would like to add a tax credit for manufacturing goods in the United States. He also has proposed imposing a tax penalty on corporations that ship jobs overseas in order to sell products back to the United States.
Conclusion
There is much riding on the outcome of
the 2020 presidential and congressional election process. The direction of any
year-end tax planning involves knowing which direction future tax rates will
go.
Year-end planning decisions typically consider
the tax consequences of both the current year and the next year. If marginal
tax rates are expected to remain unchanged or to drop, taxpayers should
consider ways defer income to the next year and accelerate deductions into the
current year. Conversely, if marginal tax rates are expected to increase in 2021,
taxpayers may wish to consider strategies to accelerate income into 2020 and
defer deductions to 2021.
Despite the economic and financial turmoil many
taxpayers have experienced in 2020, as well as the coronavirus pandemic, this
year is no exception in terms of tax planning. Understanding the possible
consequence of the presidential election and Senate race results may be useful
in helping taxpayers make informed decisions about their taxes before year-end.
[1] It should be noted that the passage of legislation also may be affected by the Senate “legislative filibuster rules” and whether these rules are maintained, revised or abolished.
For questions concerning this article, kindly contact Larry Miao (smiao@bdo.com)