Biden Administration's FY 2023 Budget Plan Calls for Tax Hikes on High-Net Worth Individuals

5/10/2022 - By Saltmarsh, Cleaveland & Gund

Individual, Estate, and Gift Taxes

The Biden administration’s fiscal year 2023 budget blueprint, released on March 28, consists of a mix of familiar proposals and brand-new initiatives that reflect the President’s policy objectives. The proposals are described in more detail in the General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals, commonly referred to as the “Green Book,” that was released with the budget, and include the President’s now-familiar calls for increasing the top individual rate to 39.6%.

The administration’s proposals affecting individuals, estates and gift taxes in its second budget look quite similar to the proposals in the first budget. High-net-worth individuals continue to be the focus of many of these proposals, which encompass raising individual tax rates, raising capital gain and qualified dividend rates, taxing exchanges between grantors and grantor trusts, imposing restrictions on grantor retained annuity trusts and taxing dispositions of appreciated property at death. A summary of the income and transfer tax proposed changes most likely to be of interest to high-net-worth individuals follows.

Individual Income Tax Rate

The administration proposes to increase the top marginal individual income tax rate from 37% to 39.6%. For taxable year 2023, the rate would apply to taxable income over $450,000 for married individuals filing jointly ($225,000 for married individuals filing separately), $425,000 for head of household filers and $400,000 for single filers.

The proposal would be effective for taxable years beginning after December 31, 2022.

The proposal to increase the top marginal individual income rate merely accelerates the increase of the top individual tax rate to 39.6% that is currently scheduled to occur beginning in 2026, which is after most of the Tax Cuts and Jobs Act (TCJA) provisions are set to expire. However, this proposal also would lower the taxable income bracket subject to the top marginal income tax rate. As a result, the proposal would impose the top marginal tax rate on filers currently below the existing top marginal income tax rate of 37%. Thus, in 2022 the top marginal tax rate is 37% for joint filers with more than $647,850 of taxable income ($539,900 for single filers and heads of household, $323,925 for married filing separately). By comparison, the proposed 39.6% tax rate is proposed to be on taxable income over $450,000 for joint filers.

Capital Gain and Qualified Dividend Income

Long-term capital gains and qualified dividend income of taxpayers with taxable income over $1 million would be taxed at ordinary income tax rates to the extent the taxpayer’s income exceeds $1 million ($500,000 for married individuals filing separately). The proposal would be effective for gain required to be recognized and for dividends received on or after the date of enactment. If the proposal for raising the ordinary income tax rate to 39.6 % becomes law, then the maximum tax rate on capital gains would effectively be 43.4% (39.6% plus net investment income tax rate of 3.8%).

Repeal of Like-Kind Exchange Transactions

Under current rules, taxpayers are able to exchange real property used in a trade or business or held for investment purposes for other real property without triggering taxable income. The administration’s proposal would effectively repeal the ability to defer gain in excess of $500,000 for each taxpayer ($1,000,000 in the case of married taxpayers filing a joint return) per year in connection with the exchange of real property. Any gain above these thresholds would be recognized as taxable gain in the year of the transfer of real property subject to the exchange.

This proposal, which would apply to all taxpayers, would be effective for taxable years beginning after December 31, 2022.

Minimum Tax Liability

The administration also proposes a minimum tax of 20% on taxable income, inclusive of unrealized capital gains, for taxpayers with a net worth in excess of $100 million. Payments of the minimum tax would be treated as a prepayment available to be credited against taxes on future realized capital gains. The minimum tax liability in subsequent years would equal 20% of (1) the taxpayer’s taxable income and unrealized gains reduced by (2) the taxpayer’s unrefunded, uncredited prepayments and regular tax. The tax due for the first year could be paid in nine equal annual installments. For subsequent years, the minimum tax could be paid in five equal annual installments.

The proposal also provides guidelines and limitations on how uncredited prepayments would be applied against future realized capital gains, in addition to providing a cap whereby a taxpayer would be fully phased into the minimum tax liability. As a result, taxpayers with a minimum tax liability and uncredited prepayments exceeding $40 million would be fully phased in.

Notably, the proposal does not require annual valuations of non-tradeable assets. Rather, non-tradeable assets would be valued using the greater of the original or adjusted cost basis, the last valuation event from investment, borrowing or financial statement purposes, or other methods approved by the Secretary, increased annually by the sum of the five-year Treasury rate plus two percentage points. Taxpayers deemed to be illiquid because tradeable assets are less than 20% of their wealth may elect to include only unrealized gain in tradeable assets in the calculation of their minimum tax liability. However, the eventual realization of gains on such non-tradeable assets would be subject to a deferral charge not to exceed 10% of unrealized gains.

Estimated tax payments would not be required for the minimum tax liability.

For unmarried taxpayers, net uncredited prepayments in excess of any tax liability from gains at death would be refunded to the estate and includable in the decedent’s gross estate for federal estate tax purposes. For married taxpayers, net uncredited prepayments remaining at death would be transferred to the surviving spouse.

The proposal would be effective for taxable years beginning after December 31, 2022.

We last saw a proposal to impose additional taxes on high-income individuals, estates and trusts in the Build Back Better Act, which proposed a surcharge on modified adjusted gross income in excess of $10 million for joint filers and $200,000 for trusts. The Build Back Better Act was approved by the House of Representatives on November 19, 2021 yet still remains stalled in the Senate. This proposal would apply to a smaller taxpayer base than the Build Back Better Act, though it would apply to more than just “billionaires,” a term not used in the budget or Green Book, but frequently mentioned in press coverage.

Transfers of Appreciated Property

The administration proposed to tax unrealized capital gains on transferred appreciated property upon the occurrence of certain realization events, which would include:

Transfers of appreciated property by gift
Transfers of appreciated property on death
Transfers of property to, or distributions of property from, trusts (other than wholly revocable trusts)
Distributions of property from a revocable grantor trust to any person other than the deemed owner or U.S. spouse of the deemed owner (other than distributions made in discharge of an obligation of the deemed owner)
Terminations of a grantor’s ability to revoke a trust – at death or during life
Transfers of property to, and distributions of property from, partnerships or other non-corporate entities if the transfer is a gift to the transferee
Recognition of gain on the unrealized appreciation of property held by trusts, partnerships or other non-corporate entities if the property has not had a recognition event within the prior 90 years. The first recognition event under this 90-year rule would occur December 31, 2030, for property not subject to a recognition event since December 31, 1939.

The proposal allows for some exclusions. Transfers by a donor or decedent to a U.S. spouse would not be a taxable event, and the surviving spouse would receive the decedent’s carryover basis. The surviving spouse would recognize the gain upon disposition or death. Similarly, transfers to charity would not generate a taxable capital gain. Transfers to a split-interest trust, such as a charitable remainder trust, would generate a gain with an exclusion allowed for the charity’s share of the gain. Transfers of tangible personal property, such as household furnishings and personal effects (excluding collectibles), are excluded.

Once a donor has exhausted his or her lifetime gift exemption, the proposal would allow a $5 million per donor exclusion from recognition of additional unrealized capital gain on the property transferred by gift or held at death. Any unused exemption by a deceased spouse would be portable to the surviving spouse, effectively making the exclusion $10 million per couple. This additional exclusion amount would be indexed for inflation after 2022. The transferee’s basis in the property shielded by this exemption would be the fair market value of the property at the time of the gift or the decedent’s death.

Payment of the tax on the appreciation of certain family-owned and -operated businesses may be deferred until the business is sold or ceases to be family-owned and operated. The capital gains tax on appreciated property transferred at death would be eligible for a 15-year fixed rate payment plan. However, publicly traded financial assets will not be eligible for the payment plan. Furthermore, family businesses electing the deferral will not be eligible for the payment plan.

The proposal would generally be effective for transfers by gift, on property owned at death by decedents dying after December 31, 2022, and on property owned by trusts, partnerships and other non-corporate entities on January 1, 2023.

Contributions of appreciated property to split-interest trusts, such as charitable remainder trusts, will no longer have the favorable treatment afforded under current law, likely making that planning strategy less attractive as a deferral planning technique. Transfers to S corporations and C corporations do not appear to generate gain, assuming those transfers qualify for the deferral provisions of Section 351. Notably, this proposal does not eliminate the $500,000 exclusion currently available to joint filers ($250,000 for unmarried filers) upon the sale of their principal residence, nor does this proposal eliminate the current exclusion on the sale of qualified small business stock.

This proposal radically alters the rules for recognition of income when it comes to capital assets. Under current law, there generally must be a sale or exchange of property to generate a capital gain. Because the proposal would “deem” a sale when in fact there was no sale, the taxpayer will not necessarily have the cash to pay the capital gains tax. Thus, the utmost care would need to be exercised to avoid the liquidity issues created by a “deemed” sale.

Grantor Trusts

Currently, sales between a grantor and his or her intentionally defective grantor trust are nontaxable events. The proposal would recognize such sales and require the seller to recognize gain on the sale of appreciated assets. Taxable transfers also would include the satisfaction of an obligation (i.e., annuity or unitrust payments) with appreciated property. The provision would apply to all transactions between a grantor trust and its deemed owner occurring on or after the date of enactment.

The proposal also would treat the payment of a grantor trust’s income taxes by the deemed owner as a taxable gift occurring on December 31 of the year in which the tax is paid, except to the extent the deemed owner is reimbursed by the trust during that same year. The provision would apply to all trusts created on or after the date of enactment.

This proposal would overturn the IRS’s prior ruling in Rev. Rul. 85-13, which disregarded transactions between a grantor and his or her grantor trust for income tax purposes.

Grantor Retained Annuity Trusts (GRATs)

Grantor retained annuity trusts (GRATs) currently do not have term restrictions or remainder interest restrictions. The proposal, however, would require a minimum term of 10 years and a maximum term equal to the annuitant’s life expectancy plus 10 years for all GRATs. In addition, a GRAT’s remainder interest would be required to have a minimum value for gift tax purposes equal to the greater of (1) 25% of the value of the assets transferred to the GRAT or (2) $500,000, but not more than the value of the assets transferred. The GRAT annuity may not decrease during the GRAT term. Further, the grantor would not be allowed to engage in tax-free exchanges of assets held in the GRAT.

The provisions would apply to all trusts created on or after the date of enactment.

This provision would effectively eliminate short-term GRATs that are commonly used in a rolling GRAT strategy to reduce the risk of a grantor dying during the GRAT term (and thereby the resulting inclusion of the GRAT’s assets in the grantor’s estate). This provision also would prohibit the use of zeroed-out GRATs.

Generation-Skipping Transfer (GST) Tax Exemption

The administration proposes to limit the benefit of the generation-skipping transfer (GST) tax exemption to certain generations. GST tax exemption would apply only to direct skips and taxable distributions to beneficiaries who are no more than two generations below the donor and to younger-generation beneficiaries who were alive when the trust was created. Also, GST tax exemption would apply only to taxable terminations occurring while any of the aforementioned persons are beneficiaries of the trust.

These proposals would apply on and after the date of enactment to all trusts subject to the GST tax, regardless of the trust’s inclusion ratio. For purposes of determining beneficiaries who were alive when the trust was created, trusts created prior to the date of enactment would be deemed to have been created on the date of enactment. Further, decanted trusts and pour-over trusts would be deemed to have been created on the same date of creation as the initial trust.

This proposal eliminates the ability to shield trust assets from GST tax in perpetuity, dramatically reducing the allure of dynasty trusts as a tax savings tool.

Intrafamily Loans

Generally, an intrafamily note carries an interest rate equal to the applicable federal rates (AFR), which have been historically low, to ensure the loan is not treated as a below-market loan or a gift. After the note holder’s death, the valuation of the note for estate tax purposes often includes a discount because the note’s interest rate is well below the market rate. The administration proposes to remedy this inconsistency in valuation by limiting the discount rate to the greater of the actual interest rate of the note or the AFR for the remaining term of the note on the note holder’s date of death. The note would be treated as a short-term note or valued as a demand loan if there is a reasonable likelihood that the note will be satisfied sooner than the specified payment date. The proposal would apply to valuations as of a valuation date on or after the date legislation is introduced.

This proposal would seemingly align the valuation of notes for both income and estate tax purposes.

This second version of the Biden administration’s Green Book does not discuss eliminating the $10,000 limit on the deduction of state and local income taxes, repealing or modifying the qualified business income deduction, reducing the lifetime estate tax exemption or increasing the estate tax rate. These items were proposed during President Biden’s election campaign in the American Families Plan or in other proposals, however, the mere absence of these items does not mean that they are not still in play. They may become important bargaining chips as the Green Book proposals are discussed in Congress.

The administration’s FY 2023 budget and Green Book provide important details regarding the proposed changes to the U.S. tax landscape. It remains to be seen whether these proposed changes will be enacted as outlined or if additional changes will be made.

Questions?
For any questions regarding the 2023 budget plan and individuals, estates and gift taxes, reach out to our Tax team!