Tax Strategy: Planning for the American Families Plan

May 25, 2021 9:00 AM

The Biden administration released the outline of its American Families Plan on April 28, 2021. The focus of the plan is to extend the tax breaks enacted as part of the American Rescue Plan Act for lower- and middle-income taxpayers. These tax breaks would be paid for with tax increases and perceived loophole closers on those making more than $400,000 per year.

Some of the proposals that President Biden campaigned on are not included in the plan. (Key provisions area below.) Some Democrats in Congress are likely to try to add their own provisions to the plan. Like the American Rescue Plan Act, the American Families Plan, if enacted, will probably have to be enacted under budget reconciliation rules in the Senate and even then will require adjustments to keep every Democratic senator on board, as the tax increase provisions are not likely to attract Republican support.

President Joe Biden speaks during a joint session of Congress at the U.S. Capitol with Vice President Kamala Harris and House Speaker Nancy Pelosi, D-California, behind him.

This might include another provision that some Democrats in higher-tax states are pushing for — repeal or modification of the state and local tax deduction limitation enacted as part of the Tax Cuts and Jobs Act.

Most commentators do not expect passage of the American Families Plan proposals until close to the August recess. The American Families Plan does not include any proposed effective date for these provisions, although it would be assumed that the extension of the lower- and middle-income tax breaks would be effective starting in 2022 to prevent any lapse in those provisions.

Increase the top individual rate

One provision would increase the top individual tax rate to 39.6%, returning the top rate to that which existed before the Tax Cuts and Jobs Act of 2017. President Biden has said that he would not raise taxes for anyone earning under $400,000.

Currently, single filers earning over $400,000 fall into both the 37% and 35% tax brackets. It is not clear if a new 39.6% bracket would start at $400,000. The effective date of the new provisions is not clear, but Congress has generally been hesitant to impose tax increases retroactively.

The timing may permit people who are seeking to minimize the impact of an individual rate increase to consider strategies such as accelerating income into the current year or doing Roth conversions in the current year.

Increase capital gains rate

Michael Nagle/Bloomberg

One would provision would increase the capital gains rate to 39.6% for high earners. This would represent a significant increase in the current top tax rate of 20% for those earning over $1 million, and result in both ordinary income and capital gains being taxed at the same top rate. After the 1986 tax reform act, both ordinary income and capital gains had a top tax rate of 28%, but that situation did not last very long.

Individuals seeking to minimize the impact of this possible change could consider accelerating capital gain realizations to before the effective date of any change or postponing realization after the effective date longer than they might have done otherwise. The plan would also end capital gains treatment even under the $1 million level for carried interests.

Currently, carried interests are still eligible for capital gain treatment if a three-year holding period is met. Hedge funds and private equity funds might move to using more deferred compensation strategies if this provision were enacted.

Ending stepped-up basis for some

President Biden had campaigned on lowering the exclusion amount for gifts and estates; however, the only estate provision included in the American Families Plan is the reduction in the availability of stepped-up basis.

There are discussions about excluding holders of illiquid assets such as family farms and family-owned businesses. There are also discussions about permitting the tax to be paid over a period of years to avoid a rapid forced liquidation of other assets. This would also require more historical tracking of basis of assets in the hands of the deceased. It would also generally violate a general principle of the tax law to only impose taxes on realization events when there are more likely to be funds to pay the taxes.

End like-kind exchange deferral for gain over $500K

The Tax Cuts and Jobs Act eliminated like-kind exchanges for personal property but retained it for real property. This proposal would also restrict it for real property.

The 1986 act had eliminated deferral of gain on the reinvestment of gain on a principal residence into another principal residence, providing instead an exclusion of gain of up to $250,000 for single taxpayers and $500,000 for joint filers. The principal residence exclusion would be retained.

The Medicare tax

One provision would expand the 3.8% Medicare tax to pass-through entity owners earning over $400,000. One of the advantages of the S corporation structure is the ability to limit payroll taxes by having separate pots of money for status as an employee and as an owner. This proposal would potentially limit that advantage based on the structure of the entity. The American Families Plan does not include an elimination of the cap on Social Security taxes, which has also been discussed.

Tax breaks for lower- and middle-income taxpayers

The American Rescue Plan Act enacted enhancements to the Child Tax Credit, the Child and Dependent Care Credit, the Earned Income Tax Credit, health insurance tax credits, and the premium tax credits under the Affordable Care Act.

The enhancements included increasing dollar limits, income limits, and increasing refundability. Those enhancements under the American Rescue Plan were effective only for 2021. The American Families Plan would extend the Child Tax Credit through 2025 and make the other enhancements permanent.

IRS funding

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The American Families Plan proposes to raise significant revenue by increasing IRS funding by $80 billion to permit the agency to increase audit activity of wealthy taxpayers and estates and large corporations. Some commentators suggest that the estimated $700 billion in revenue from the increased IRS funding is overly optimistic. Financial institutions would have new information reporting requirements to help the IRS track earnings from business and investment activity.