We previously discussed the Biden administration’s plan to give the IRS access to bank account and credit card transaction data here: https://www.oconnorlyon.com/blog/2021/6/24/government-proposal-to-give-individual-and-business-bank-account-and-credit-card-transaction-data-to-the-irs-annually but in this article, I want to focus on proposals that are going to raise taxes for individuals.
American Families Plan Income Tax Proposals
A section from the American Families Plan titled: “Strengthen Taxation of High-Income Taxpayers” proposes an increase to the income tax rate, an increase to the tax rate applicable to capital gains, adjustments to the taxation of gifted and inherited property, and changes to the net investment income and self-employment taxes.
Increased Tax Rates
The administration’s first step to increase the tax applicable to high income taxpayers is a flat increase to the highest marginal tax rate. Currently, the highest tax rate is 37%. This proposal would increase that rate to 39.6%. This rate would apply to income over $509,300 for married filing jointly filers and income over $452,700 for single filers.
Long-Term Capital Gains Taxed at Ordinary Income Rates
The second step in this effort to increase the tax paid by high income individuals is to change the manner in which capital gains and qualified dividends are taxed. At present, for high income taxpayers, long term capital gains and qualified dividends are taxed at the reduced rate of 20%, this proposal would remove this beneficial tax treatment and would instead tax this income at ordinary income rates. The current iteration of this proposal would apply these increased rates to income amounts in excess of one million dollars for joint filers and a half million for married filing separately filers.
Income Tax on Gifts
The third significant component of ‘strengthening the taxation of high-income taxpayers’ involves the taxation of gifted property as well as the taxation of inherited property. Currently, when you gift property, no income tax is applied to you with regard to that gifted property. The individual receiving the gift also isn’t taxed at the time of the gift. At a later date, if the individual that received the gifted property then sells that property, they will have taxable income.1 This proposal would change the tax consequences for the gift giver, subjecting them to tax based on the increase in the value of the property. Donors will effectively be treated as though they sold the property (technical term being – a recognition event-) on the date of the gift.
Income Tax on Growth of Assets Upon Death
Currently, when an individual dies and their property passes to their heirs, the heirs receive a step up in basis to the fair market value of the property on the date of death, and there is no income tax paid with regard to the transfer of the property from the deceased to the heir. There is still an estate tax that will apply to estates over $11.7 million (per person), but there is no tax based on the increased value of the assets prior to the date of death. This proposal would impose a tax on the estate based on the increase in value of the property. For example, if an individual bought real estate for $200,000 in 1989 and held that real estate until they died during 2022, if on their date of death the property was worth $800,000, the estate would have $600,000 of taxable income.
Expansion of Self-Employment Tax, Medicare Tax, and Net Investment Income Tax
The fourth component of the current administration’s effort to strengthen taxation of high income taxpayers is the expansion of the applicability of the net investment income tax and the Self-Employed Contributions Act (SECA). At present, the net investment income tax is an additional 3.8% tax that applies to your passive income (rent, royalty, interest, dividends, capital gains etc). This tax only applies to individuals with income over $200,0002. Currently, SECA applies at 12.4% to self-employment income up to $142,800 and an additional 2.9% Medicare tax on all employment//self-employment earnings (the additional 2.9% is reduced to .9% for income over $200,0002). This proposal would broaden the application of these taxes and would remove the 2% Medicare tax reduction that occurs over $200,0002.
There are plenty of tax policy debates to be had with regard to these proposed changes. Is it better to add additional avenues of increased taxation for high income taxpayers? Should we apply an income tax in addition to the gift tax on property that is gifted? Should we tax estates on the increase in the value of the deceased individual’s property in addition to the estate tax? Is it appropriate to increase the tax rates applicable to high income taxpayers? Should we fundamentally change the method of taxation of investments that have been held for a long period of time for high income taxpayers?
Retroactive Application of Significant Tax Reform Is Wrong
One detail that I hope we can all agree on is that it would be unfair to implement any of these proposed changes prior to these proposals becoming law. Each proposal in the administrations fiscal year 2022 proposals has an applicability date. Most of these proposals would not take effect until after 2021, the current year. However, one of the most significant changes, the adjustment to the taxation of long-term capital gains, has a proposed effective date of the announcement of the proposal. This would effectively adjust the taxation of events that occur prior to these changes being passed into law. You don’t need to be sympathetic to high income taxpayers to accept that the proposed implementation of this change would be unreasonable. Individuals should not be punished for decisions that are made based on the current laws.
Countless decisions are made by taxpayers in an effort to make their income as tax efficient as possible in accordance with current tax policy and the current tax laws. Individuals should have an opportunity to adjust their investments under the currently active laws and policies before the tax consequences of decisions they made in accordance with current tax policy are dramatically changed. Imagine if this type of decision were to suddenly apply to tax efficient decisions that you’ve made in the past. For example, imagine that Congress suddenly decided that pre-tax retirement accounts should never have been pre-tax, and then imposed a tax on the gross contributions to all pre-tax retirement plans. The substantial reduction to taxpayers’ retirement accounts could significantly extend the number of years that an individual would have to continue working prior to retirement. This is not a change that has ever been proposed, but it is a powerful example to demonstrate the negative impact of substantial tax law changes applying retroactively.
1. At present, for the individual that receives and then later sells gifted property, the capital gains calculations require you to know the fair market value (“FMV”) of the property on the date of the gift, the donor’s adjusted basis in the gifted property, and the amount of gift tax paid by the donor on the gift. If the FMV on the date of the gift is higher than the gift giver’s basis, use the donor’s basis as the basis and increase your basis by any gift tax paid by the donor on the difference between their adjusted basis and the FMV at the time of the gift.. If the FMV on the date of the gift is less than the gift giver’s basis, then use the donor’s basis as your basis when the sale results in a gain and the FMV as your basis when the sale results in a loss.
2. The actual net investment income tax and Medicare tax thresholds vary by filing status. Married filing jointly $250,000, married filing separately $125,000, single/head of household $200,000 and qualifying widower//dependent child 250,000. It’s also worth noting that these thresholds are not adjusted for inflation.