Potential significant changes to watch for
Now that we have a single party controlling the House of Representatives, Senate and White House, sweeping legislation change is an imminent possibility. By peeking into President Joe Biden’s proposed tax plan, we can determine some of the most likely changes that could be passed into law, enabling us to plan for those most impactful to individuals and businesses.
President Biden’s income tax plan focuses on corporate taxation, higher-earning individuals and estate/gift tax changes. It should be noted these are still only concepts and have a long way to go before becoming law.
The Tax Cuts and Jobs Act of 2017 marked a significant change to corporate taxation. The corporate tax rate moved from a tiered structure to a flat 21% rate. A qualified business income deduction was introduced for pass-through entities.
The Biden tax plan appears to keep the structure of the Tax Cuts and Jobs Act but proposes significant changes that may impact higher-earning business owners.
What these changes mean for business
High-earning business owners would need to prepare for dramatically higher taxes.
Income from C-corporations is taxed twice, once at the corporate level and again when it is distributed via a dividend to stockholders. Currently, a business owner would pay the 21% corporate rate and the 23.8% maximum qualified dividend rate. But if the corporate rate moves to 28% and the maximum dividend rate moves to 39.6%, this would mark a significant increase.
Potential solution: Some C-corporation business owners may be better served by issuing themselves a higher salary or bonus; however, if they increase their earned income above $400k, this may subject them to the proposed additional 12.4% Social Security tax.
The 26% retirement plan credit instead of the current tax deduction could cause you to alter your savings plan. Regardless of your income, if you save in a retirement plan, you would receive a 26% credit.
CHANGES TO WATCH FOR
1 Increase in corporate tax from 21% up to 28%.
2 Phase out of the QBID for those with income above $400,000. Currently non-specified service businesses may still be able to deduct.
3 Increase in the top individual tax bracket from 37% to 39.6%.
4 Long-term capital gains and qualified dividends taxed at ordinary income rates for those with income above $1 million. Note: Washington state is also proposing a capital gains tax of 9%.
5 12.4% Social Security payroll tax on earned income above $400,000.
6 26% retirement plan credit instead of the current tax deduction.
7 Revert Federal Gift and Estate Tax exemption to 2009 levels: $3.5 million and a 45% tax rate. Potentially eliminating the step up in basis at death.
8 Raise the federal minimum wage from $7.25 to $9.50 this year, escalating to $15 by 2025.
Potential solutions: For people in lower tax brackets, tax-deferred savings would be encouraged. For those in higher tax brackets, it may be preferrable not to save in a tax-deferred account if you believe you will have to withdraw at higher income tax rates later. This could push more high earners to Roth savings, or business owners may shift to plans with higher employer contributions, to reduce income.
Business transition planning will have new importance.
Reducing the Federal Estate Tax Exemption, combined with eliminating the step up in basis at death, would make business transition planning much more important. With the current $11.7 million exemption, step up in cost basis, and portability, very few estates pay tax. A step up in cost basis allows an inheritor to receive a new cost basis equal to the fair market value at the time of death and sell tax-free. Many businesses have a very low cost basis, so if the estate exemption is lowered to $3.5 million and the step up in basis is eliminated, higher capital gains taxes would be imposed, and if transitioning at death is considered a deemed disposition (sold), the tax consequences would be severe.
Potential solution: Plan far in advance for estate and business transitions. Techniques such as developing a gradual business transition plan, removing the business from your estate or providing other sources of estate liquidity to pay the taxes may be critical for your business to endure.
Although none of this is yet law, understanding how these changes may impact you or your business can be helpful in planning ahead for 2021 and beyond. If we do see a comprehensive tax package, the implementation date will further impact strategies.
For an in-depth analysis of these tax points and links to helpful sources, go to https://financialplaninc.com/blog/.
Devin Wolf, CFP® is a Principal and Lead Advisor at Financial Plan Inc. in Bellingham. With a special focus on business owners, high-level executives, and CEOs, Devin makes a point of staying up to date on tax codes and how they might affect his clients. His expertise with corporate retirement plans and estate tax planning enable him to help his clients navigate complex financial situations as well as accumulate and transition wealth.