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American Families Plan: Capital gains and repeal step up in, estate tax changes out . . . for now

On Wednesday, April 28, 2021 President Biden unveiled his American Families Plan, the third element in the Build Back Better plan, addressing "human infrastructure" and containing proposals on education, direct support to children and families, and the extension of tax cuts for families with children. President Biden proposes to offset the third element with tax increases focused on the wealthy.

The infrastructure (loosely defined) sections of the Build Back Better plan amount to approximately $4.3 trillion – $2.5 trillion under the American Jobs Plan and $1.8 trillion and the American Families Plan – and are among the most ambitious government agendas in decades, coupled with the already passed American Relief Plan coming in at $1.9 trillion. For those counting, the combined amount for the proposed three packages is a staggering $6.2 trillion in additional federal spending.

The $1.8 trillion American Families Plan is composed of $1 trillion in spending and $800 billion in tax cuts and credits for moderate/lower income families, with the spending partially offset by income tax increases for wealthy Americans, an increased IRS budget for compliance, and notably does not include any of the estate and gift tax changes proposed during the campaign (other than the associated elimination of step up in basis).

Now that President Biden has laid out a sweeping vision, Congress must translate it to legislation and determine what has the votes to become law. Read on to get into the nitty-gritty of the proposals.

The Biden Administration proposes to increase income taxes on the wealthy and provide more resources to the IRS to enhance compliance. The headline increases relate to taxing capital gains at death, the top ordinary income tax rates, and the elimination of the "step up" in basis rule.

  • Increase Top Income Tax Rate. The rate would be increased to 39.6 percent (from 37 percent) for taxpayers within the top 1 percent, restoring the rate to the pre TCJA level.

  • Subject Long-Term Capital Gains to Income Tax Rates. The rate to long-term capital gains would be increased to 39.6 percent for households with an adjusted gross income exceeding $1 million.

  • Eliminate the Step Up in Basis. Under current law, the income tax basis of property acquired at death is its fair market value at death rather than its original cost. Under the proposal, the appreciation prior to death would become a taxable event upon the death of the owner. Significantly, the administration has stated this change will come with protections that would exclude family-owned businesses and farms if the heirs continue to operate the business.

  • Eliminate the Carried Interest Rule. Income associated with "carried interests" would be taxable at the ordinary income tax rate rather than the current law preferential capital gains rate.

  • Eliminate "Like Kind" Exchanges for Gains in Excess of $500,000. A "like kind" exchange transaction is a swap of one real estate business or investment property for another that enables deferral of capital gains taxation. The proposal would eliminate that deferral for gains in excess of $500,000. Unclear at this point is whether or not this change will apply to just 1031 exchanges or include 1035 as well.

  • Permanently Extend Current Limitation that Restricts Large Excess Business Losses. This provision restricts the current deductibility of "excess business losses.” The CARES ACT had removed the excess business loss limitation for 2018, 2019 and 2020, but allowing it to go back into effect in 2021. This limit was created by the TCJA and was originally scheduled to be in effect from 2018 through 2026 and had been scheduled to expire with the rest of TCJA’s individual provisions in 2027.

  • Increase IRS Enforcement Budget. The administration will ask for about $80 billion over 10 years to overhaul the tax administration and provide the IRS the resources and information it needs to investigate large corporations, partnerships and high-net-worth individuals. American households with less than $400,000 in annual income would not be targeted, according to the administration.

Estate Tax Changes?

Surprisingly, the Biden Administration did not include any of the estate and gift tax changes that they proposed during the campaign.

While these changes to the estate and gift tax system are not included in the American Families Plan, the proposed elimination of the step up in basis for income tax purposes would have a significant impact on the estate and tax planning of wealthy families.

  • In other words, the elimination of the step up in basis creates the same liquidity and tax issues as a traditional estate tax on assets passed down to the next generation.

Under the proposed framework, an individual would have to juggle a number of exemption limits with corresponding tax frameworks – gifting, capital gains, and estate tax. As presently constructed, a family with assets in excess of $2.5 million (including capital gains exemptions of $2 million per couple and $500k for real estate per couple) would be subjected to the increased tax rate in capital gains appreciation at death. For families with assets above the estate tax exemptions of 11/22 million per individual and couple could see a rate of closer to 65% when including capital gains and estate taxation. Such a change significantly increases the complexity of recording keeping and compliance.

Further, the absence of any proposed changes to the estate and gift tax system currently does not mean that such changes will not be proposed at a later date. There continues to be a strong interest among many leading Democrats to expand the estate and gift tax as a means to target inherited wealth.

This material is intended for informational purposes only and should not be construed as legal or tax advice. It is not intended to replace the advice of a qualified attorney, tax advisor, or plan provider.

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