It is not unreasonable to expect that federal tax policy will be reshaped after a change in political control of the White House, the US Senate and the US House of Representatives. What may be inappropriate, however, is making tax planning decisions in anticipation of possible changes to the Internal Revenue Code (the “Code”). Reactionary planning could be disastrous if not well thought out and based on sound business judgment. In today’s world, tax advisors and their clients need to be careful about tax planning and related decisions.
Looking through a lens focused solely on federal taxation, commentators, accountants, and taxpayers alike seem concerned about the future. Possible tax policy changes on the horizon that are being discussed include:
- Reduce the lifetime estate and gift tax exclusion under Code Section 2010, which is currently calibrated at $ 11.7 million, to $ 6 million (where it is expected to return in 2026) or reduce it to an even lower amount.
- Increasing the highest tax rate on capital gains under Code Section 1 (h) from 20 percent to 35 percent, or even eliminating a preferred capital gains rate altogether, thereby taxing capital gains at the same rates, will tax normal income (exactly what is in the tax reform law of 1986).
- Eliminated Code Section 1031 so that deferred property exchanges are no longer permitted. Effective 2018, the Tax Reduction and Employment Act (“TCJA”) eliminated taxpayers’ ability to defer profits under Code Section 1031 on exchanges of personal property. Eliminating the application of this section of code to real estate can be a logical extension of the TCJA.
- Eliminated the flat corporate tax rate of 21 percent under Code Section 11, returning to the bracketed rates of 35 to 40 percent on the high end.
- Increase in the highest individual tax rate according to Code Section 1 in the two upper brackets from 35 and 37 percent to 37 and 39.6 percent respectively. Also, reduce the top two parentheses to allow taxpayers to enter the higher tax rates at lower values of adjusted gross income.
- Return the Alternative Minimum Tax for Businesses (repealed as part of the TCJA) to the Code under Section 55.
- Code Section 1411 increase in net investment income tax from 3.8 percent to 4.5 percent.
- Eliminated the 20 percent “Qualified Business Income” Deduction under Code Section 199A (created by the TCJA).
- Maintaining the $ 10,000 deduction limit for individuals for state and local taxes paid (despite the fact that the limit put into the Code by the TCJA was a compromise for lower individual income tax rates).
While none of these changes in federal tax policy are out of the realm of possibility, taxpayers shouldn’t let fear get in the way of sound business judgment. In the past few months, we’ve seen taxpayers make decisions that they certainly wouldn’t have made without the fear of adverse tax changes on the horizon. Some of these hectic decisions include:
- Selecting rate reporting under Code Section 453 in anticipation of an increase in both capital gains and individual income tax rates. Hopefully the decision was well thought out and at least considered: (i) the time value of money, (ii) the taxpayer’s ability to pay taxes now on profits that will come some time in the future, (iii) the expected one Increase in capital gains rates, (iv) the impact of today’s use of funds for taxes on the taxpayer’s ability to invest / operate, and (v) whether the taxpayer can change direction if tax rates do not rise enough to warrant the decision (retrospect can 20/20).
- Giving away wealth to consume all of the taxpayer’s current estate for life; and excluding gift taxes in the expectation that the foreclosure will be significantly reduced in the near future. Using the currently $ 11.7 million exclusion sounds like a prudent decision. However, taxpayers and their tax advisors must carefully consider the decision before a taxpayer steps into such an expansive gift plan, including (i) whether the taxpayer can live his or her life as expected without the scattered wealth, (ii) whether the taxpayer is his or her interferes with their other wealth transfer plans (e.g. future charitable donations), (iii) whether the gifts (amounts and recipients) are well thought out, and (iv) whether the gifts (direct gifts or gifts in) trusts) are appropriate.
- Sell capital assets now to avoid increasing or eliminating income tax rates on capital gains. Of course, if it makes sense to sell an asset today for non-tax reasons, the ability to avoid the effects of adverse capital gains tax changes in the near future makes perfect sense. However, the hasty sale of a capital asset may not make economic sense, especially if the terms or selling price are undesirable.
More than ever, it is of the utmost importance that taxpayers carefully consider the business and tax implications. Any planning must take into account the possibility of changes in the law and / or the circumstances of the taxpayer and contain alternative plans so that the taxpayer can adapt to changes.
After the TCJA came into force on 22. December 2017, numerous taxpayers ended the S corporation elections and pursued the favorable flat tax rate of 21 percent according to Code Section 11. However, we warned them that the alluring flat corporate tax rate may not be here – stay very long, they are still going out and going to the land they thought was full of gold and jewels. Unfortunately, these taxpayers will not be able to re-elect S status until five years have passed since their decision to end S corporation status was due to a change in tax rates under Code Section 1362 (g) on the termination date. If the termination took effect on January 1, 2019, these taxpayers will not be able to restore S corporation status until January 1, 2024. In the event that the Code Section 11 Flat Rate Corporate Income Rate is increased significantly or the Pre-TCJA The parenthesized corporate income tax rates will be restored prior to 2024. They may have to endure the change in tax rate for a few years before they can choose S status again.
The keys to proper tax planning are:
- Thorough examination of the current facts and circumstances of the taxpayer;
- Carefully examining the potential for changes in both tax laws and the taxpayer’s circumstances;
- Thoroughly examine the short-term and long-term implications of a plan for the tax and non-tax aspects of the taxpayer’s life;
- Increase the flexibility to change the plan if the facts involved change, tax laws change, and / or any part of the hypothesis on which the plan is based turns out to be inaccurate; and
- Make sure the taxpayer’s wants and goals are not overlooked or pushed into the background in order to generate tax savings.
Given the looming changes in tax policy, careful and thoughtful tax and business planning is increasingly important today. Planning solely out of fear of changes in tax law can lead to disaster.