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A Strategy to Offset Higher Taxes

by Jonathan S. Henry, CPA, CFP®

President Biden will soon turn his attention to comprehensive income tax reform which is expected to result in higher taxes for wealthy individuals.  For taxpayers who routinely give to charity, a donor-advised fund might be a useful tool to offset the anticipated increases in tax liabilities.

The Biden Administration campaigned with a promise to increase income taxes for wealthy individuals, defined by the campaign as those earning greater than $400,000 a year.  With the recent passage of the American Rescue Plan Act, President Biden and Congress seem poised to now focus on comprehensive changes to current income tax law.  The White House is concurrently rolling out a plan, coined “Build Back Better,” to gather support and consensus for the next phase of its economic agenda – a variety of programs that would invest in infrastructure, education, carbon-reduction, and working mothers.  Build Back Better could cost an estimated two to four trillion dollars.  Biden and his team believe the proposal to increase spending requires an agenda with a two-pronged approach, with the second being an increase in tax revenue to fund the desired infrastructure spending and protect the nation’s long-term financial stability.  A sample of some of the income tax increases proposed by the Biden campaign are listed below:

·         Decrease the top tax bracket from $622,000 to $400,000 and increase the top tax rate from 37% to 39.6%.

·         Tax long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6% on income above $1,000,000.

·         Eliminate the step-up in basis for capital gains taxation.

·         Cap the tax benefit of itemized deductions to 28% of value for those earning more than $400,000.

·         Phase out the qualified business income deduction (Section 199A) for filers with taxable income above $400,000.

·         Increase the corporate income tax rate from 21% to 28%.

For those individual taxpayers who are charitably inclined, the utilization of a donor-advised fund is an excellent strategy to offset income.  A donor-advised fund acts as a charitable investment account used over time to support the charitable organizations you care about.   You can establish a donor-advised fund by donating cash, appreciated securities, or non-publicly traded assets such as an interest in a private business.  The donation is generally eligible for an immediate tax deduction, but gifts can be made from the donor-advised fund to charities you choose over the course of many years, perhaps even your lifetime.  While you are deciding which charities to support, your donation can be invested, and the growth is tax-free.  Essentially you are taking the tax deduction when it is most valuable to you by pre-funding your charitable giving for the future.  As a bonus, all of your future giving can be organized and administered in a single place.

Funding a donor-advised fund is particularly useful during a high-income year.  Examples of financial events that would cause a high-income year include selling a business, exercising stock options, receiving a large bonus, selling real estate, and rebalancing an account with concentrated low-basis positions.  A portion of this income can be offset by funding your future charitable giving in a donor-advised fund.  Assume you plan to sell your business for $10,000,000 in 2021 and your basis is low, which means you will realize significant capital gains when you file your 2021 tax return.  You also plan to continue charitable gifting which has averaged $50,000 per year.  Rather than give $50,000 to charities each year for the next ten years, you could fund ten years of gifting in 2021 by donating $500,000 to a donor-advised fund and create a $500,000 charitable deduction on your 2021 tax return to offset proceeds from the sale of your business.   Gifts to charities can then be made in future years from your donor-advised fund.

If you find yourself in a high-income year due to a financial event, or a high tax year due to income tax reform (or both), consider discussing a donor-advised fund with your wealth advisor.   There are additional charitable planning techniques, including the use of charitable trusts, that your advisor may wish to explore given your unique situation.

2020 Year-End Tax Planning

by Chris Sutherland, CPA

Year-end tax planning often comes with a bit of art sprinkled in with the science. Thanks in part to the January Senate runoffs in Georgia, this year presents even more challenges. It is not unusual to see material tax legislation in years in which the presidential party changes. We are likely to see that continue in 2021. How impactful those changes will be hinges on the two Senate races in Georgia. Democrats need to win both seats to effectively win the Senate and thus control Congress and the presidency.

Much of what has been said and written about President-elect Biden’s tax plan highlights the impact on high earners –  those making $400,000 or more. We will focus on those provisions of his plan.

  • Ordinary Tax Brackets – The top ordinary tax bracket reverts to 39.6% from the current rate of 37% and applies to those making over $400,000.
  • Capital Gains and Qualified Dividends – For those with income above $1 million, long-term capital gains and qualified dividends would be taxed at 39.6%. Combined with the 3.8% Net Investment Income Tax, the total capital gains tax would be over 43%, nearly double the current rate of 23.8% for high-income taxpayers.
  • Step-up Basis – Also of note regarding future capital gains taxes, Biden has proposed eliminating the step-up in cost basis that allows for basis to be adjusted to fair market value at the time of death. Under current basis step-up rules, heirs can effectively sell inherited assets tax-free.
  • Social Security Tax – A 12.4% Social Security payroll tax would be imposed on earned income over $400,000. Like the current Social Security tax, this would be split between employees and employers. The new tax would create a “donut hole” in which earned income between $142,800 (2021 wage base) and $400,000 is not taxed.
  • Itemized Deductions – Biden has two proposals impacting itemized deductions:
    • His plan reinstates the Pease limitation for those making over $400,000. This is a reduction of total itemized deductions by 3% for every dollar of income over $400,000.
    • The Biden plan also caps the benefit of itemized deductions at 28%. This provision has the potential to impact more taxpayers, but Biden has pledged to prevent the limitation on those making less than $400,000
  •  Qualified Business Income (QBI) Deduction – The QBI deduction would phase out for taxpayers with taxable income above $400,000. Currently, certain businesses can claim a deduction of 20% of qualified business income.
  • Corporate Tax – One of the major provisions of the 2017 Tax Cuts and Jobs Act was a reduction in the corporate tax rate from 35% to 21%. Biden’s plan would split the difference and raise the corporate rate to 28%. He has also proposed a corporate alternative minimum tax that would impose a 15% tax on book profit should ordinary corporate taxes not reach that level.

The greatest impact of President-elect Biden’s plan falls on the top 1% of taxpayers. According to the Tax Foundation, the top 1% will see a reduction of after-tax income in excess of 11% in 2021. So what can you do now to lower your tax bill?

Conventional wisdom in times like these, with expected higher tax rates on the way, is to accelerate income and defer deductions. Unfortunately, it’s not that simple. For example, with the proposed limitations on itemized deductions, you might be better off taking deductions in 2020. Another consideration for those making over $400,000 is a Roth Conversion.  Converting funds from a traditional IRA to a Roth IRA is an easy way to accelerate income that also comes with the benefit of future tax-free growth. Finally, while some tax reform is likely next year, the ability to pass all the provisions listed above comes down to control of both chambers of Congress. And that will not be decided until January.

Tax planning is never a “one-size-fits-all” approach, so contact your tax professional to better understand what actions you can take before the end of the year.

Chris Sutherland is a Principal and Wealth Advisor in Trust Company’s Charlotte office, where he works directly with clients to provide integrated wealth management solutions.