On November 3, 2021, the House Rules Committee released a revised version of HR 5376, the Build Back Better Act, which would impose two new income tax âsurchargesâ on high-income taxpayers, effective January 3, 2021. January 1st. 2022. For individuals, a 5% surtax would apply on modified adjusted gross income (MAGI) over $ 10 million and a 3% surcharge on MAGI over $ 25 million. For a married person filing separately, the MAGI thresholds would be $ 5 million and $ 12.5 million, respectively.
For trusts and estates, the Act would impose these surcharges at thresholds 98% less than those of individuals: 5% on MAGIs over $ 200,000 and an additional 3% on MAGIs over $ 500,000. At present, these surcharges are simply offered. They have not yet been voted on in the House, and even if they are passed, the Senate could remove them from the final bill.
Indeed, these increases would create an âintermediateâ tax bracket of 31.8% on capital gains, roughly halfway between the current maximum tax rate on long-term capital gains of 23.8% and the maximum rate of ordinary income tax of 40.8%. Aside from a handful of highly paid business executives, athletes and artists, the proposed surcharges, if adopted, are likely to affect (and may surprise) two main categories of taxpayers: (1) entrepreneurs who sell a business; and (2) non-granting trusts.
So what now? The most obvious strategy to avoid the proposed surcharges would be to recognize as much income as possible before the effective date of January 1, 2022. Apart from accelerating earnings and other income, what other strategies are available?
Entrepreneurs looking to avoid the impact of the proposed surtaxes may want to spread the gain from the sale of a business among multiple tax years or multiple taxpayers. For example, they can:
- Structure the sale of the business to recognize the gain in stages, accepting a remittance note or retained equity instead of cash. This would allow the seller to recognize reduced amounts of gain over time when the buyer makes payments of instruments or upon a subsequent sale of retained equity.
Transfer business interests to other taxpayers prior to the sale and in pursuit of the seller’s broader planning goals. For example, the seller may wish to transfer business interests to family members, non-grantor trusts for their benefit, or charities. Each owner will then recognize their proportional share of the gain, thereby lessening the impact of the sale on a taxpayer’s MAGI for the purposes of surcharges. Taxpayers who wish to transfer business interests should do so for as long as possible before finalizing the sale of the business to avoid the transfer being treated as an illegal disposal of income, which applies once the right of the taxpayer to collect the income is virtually certain. (See Treasury Regulations, article 1.671-1 (c); Chrem v. Commissioner, 116 TCM (CCH) 437 (2018)).
- Transfer the business interest to a Charitable Remainder Trust (CRT), which, as a non-taxable entity, will avoid immediate recognition of gain on interest held in trust at the time of sale. (Note: this strategy will not work with shares of Company S, as a CRT is not an authorized shareholder of Company S.) Instead, the seller will recognize this deferred gain upon receipt of the annual distributions from the CRT generally for the lifetime of the seller or the joint life of the seller and the seller’s spouse.
- If the business is a C corporation, use the Internal Revenue Code Section 1202 Qualified Small Business Stock Exception where possible, which may result in the exclusion of up to seller’s $ 10 million MAGI gain in the year of the transaction.
Unlike entrepreneurs, trustees of non-granting trusts will need long-term or year-over-year solutions to proposed surcharges, rather than focusing primarily on one significant fulfillment event. This is because taxpayers may reconsider or restructure non-grantor trusts, especially trusts that were created primarily to reduce state income taxes, as proposed federal surcharges may outweigh state tax benefits. provided by these trusts. For existing non-grantor trusts, or in cases where a non-grantor trust remains appropriate for other reasons, the trustees may consider the following strategies:
- âActivateâ the grantor’s trust status for a year in which the trust’s MAGI would otherwise trigger a surcharge. IRC section 675 (3) provides that a trust will be treated as a grantor’s trust for any year in which the grantor borrows from the trust without adequate collateral and has not repaid the loan by termination. of the year. (Note: Taxpayers should be careful to avoid recognition of a gain when converting from transferor to non-transferor trust status.) Under this strategy, the settlor could potentially borrow trust assets shortly before the transfer. end of the year, repay those assets shortly thereafter and avoid the lower MAGI thresholds for non-grantor trusts that would otherwise apply.
- Distribute the net distributable income (RNI) of the trust so that the responsibility for paying income tax is vested in the individual beneficiaries, rather than retained by the trust. Distributions may be made directly to the beneficiaries, to a flow-through entity owned by the beneficiaries, or to creditor-protected trusts that the beneficiaries are deemed to own for income tax purposes. Although the DNI generally excludes capital gains income, a trust can be amended to include this income in the DNI; liberal distributions to individual beneficiaries under this broad definition of income would further reduce the trust’s MAG. The Trustee may be able to include capital gains in the DNI by virtue of its adjustment power under the Uniform Principal and Income Act, or as a “reasonable and impartial exercise of discretion” under by Treas. Reg. Section 1.643 (a) -3 (b).
- Invest some or all of the trust’s cash reserves in private placement life insurance, which, if properly structured, should reduce the trust’s MAGI by excluding the growth in cash value from tax of the police.
It is difficult to reduce MAGI by generating deductible expenses. For example, deductible investment interest charges reduce MAGI, but charitable contributions typically do not. Essentially, MAGI is adjusted gross income. The change in income is therefore more likely than extravagant spending to reduce the impact of the new surcharges.
There is no certainty that these surcharges will be enacted, let alone in their current form. We will continue to monitor the progress of the law and keep you informed of any new developments.