Higher taxes for millionaire investors are coming - the question is exactly what the new rates will be. When some state taxes are added in, some HNW individuals could face a hefty bill - assuming rates aren't subsequently repealed. What can clients realistically do?

With the Biden administration, federal and some state lawmakers pushing for higher capital gains taxes on HNW individuals, wealth advisors are setting out ways in which clients can shield themselves.

Reports say that White House officials advocate raising federal CGT to 43.4 per cent from the existing top rate of 23.8 per cent. The administration wants to impose CGT on taxpayers who earn more than $1 million at the personal income tax rate – which Biden also wants to raise to 39.6 per cent from 37 per cent. With some states imposing capital gains taxes on gains, such as the 13.3 per cent rate in California and 11.85 per cent rate in New York, that’s almost 60 per cent - a hefty blow for HNW individuals on the coasts. 

Although specific details could be changed by political horse trading, the fact that Congress is in Democrat hands and there is a regular drumbeat of concern about wealth inequality, suggests that some sort of CGT increase is likely. 

Gregg Coury, chief executive of The Coury Firm (Family Wealth Report profiled his family-run wealth firm yesterday) said that he and his colleagues have been positioning clients’ liquid portfolios, private businesses, and estate structures in case of higher taxes. 

“We are not surprised to see an increase in capital gains taxes from the Biden administration but feel the proposal is quite aggressive,” Gregg Coury said in a note. “We are expecting a tax increase but are hopeful that any increase in the capital gains rate will not overly weigh on investor sentiment or corporate earnings.”

Coury doesn’t expect a rise as dramatic as some media reports have flagged.

“We believe a tax increase would be around 28 per cent, and the market response seems to suggest a more modest approach as well. If a tax increase is passed, we believe it will most likely take effect in 2022,” he said. 

Debate over impact
A report yesterday (CNBC), quoting UBS research, said that about three out of four US investors will not be hit by such a CGT hike anyway because it will only affect millionaires, rather than most investors holding structures such as 401(K) plans. Foreign investors will not be affected. However, that may be scant consolation to HNW individuals who might be hoping to liquidate assets prior to retirement or to fund a new business.

In a blog post last October - just before the elections - UBS said that paying taxes on gains now to forestall higher rates later isn’t necessarily a smart strategy for people holding assets for long periods. “If you assume a 5 per cent [equity] growth rate and a 43.4 per cent future tax rate, you would be better off deferring capital gains and paying the higher tax rate if your expected holding period is longer than 18 years,” the bank said. 

UBS continued: “In most circumstances, we expect that families will be able defer most of their capital gains at least 20 years, and in many cases they may be able to benefit from the step-up in cost basis when they pass assets to their heirs, thus potentially avoiding the capital gains taxes altogether. As a result, even assuming a gigantic increase in the tax rate, it will rarely make sense to liquidate assets and pay a huge tax bill in 2021. In fact, the prospect of higher capital gains tax rates only adds to the value that investors can unlock through tax-optimization and tax loss harvesting strategies.”

Another Swiss bank weighed into the US tax debate. 

That [proposed new CGT] rate will likely get scaled down in Congress, but be approved nonetheless. As the US administration looks for new financing sources, so will other governments that have supported their private sectors during the pandemic. We expect a gradual rise in corporate tax rates. This is all in keeping with our `who pays the bill’ theme and we continue to emphasise that strong cashflow generation is a key criterion in stock selection,” César Pérez Ruiz, head of investments and chief investment officer at Pictet Wealth Management, said. 

What do do?
Gregg Coury said that advisors must be “very proactive when looking at their clients’ accounts and overall objective.”

“Advisors need to look at the portfolio holistically and determine if capturing gains at today’s rate is in the client’s best interest,” he said. 

“Advisors must inform the client of the potential impact to their after-tax return. It is difficult to ignore such a high proposed increase to the capital gain rate – this may certainly influence capturing gains prior to year-end. We believe the proposed increase in capital gains is just the beginning of broader tax reform, and holistic planning is essential in maximizing the after-tax return on the client’s overall balance sheet,” he said. 

There’s debate on whether higher CGT will hit equity markets. UBS is skeptical. Historically, changes in the capital gains tax rate have had almost no impact on overall market returns. In fact, the last time the capital gains tax rate increased (in 2013), the S&P 500 rose by about 30 per cent. And capital gains tax rates have very little relationship with valuations, UBS said.

That said, high CGT rates on millionaires can, according to economists such as Arthur Laffer - famous for his analysis of marginal rates on revenues and growth - stifle business formation and benefit incumbent companies against start-ups and challengers. In the long run, high marginal rates sap the very entrepreneurial spirit that has propelled the US economy, such as its technology sector. (This publication reviewed a recent book that claimed the case for tax incentives is exaggerated. We concluded that its critique was faulty.)

The prospect of higher taxes is a reason why the US has fallen down global economic freedom rankings. A measure from the Heritage Foundation, a think tank, puts the US in 20th place, lagging far behind countries such as Switzerland, Australia and Singapore, while Hong Kong has vanished from the rankings after having been a leader for years.

This news service also recently spoke to David Lesperance, an advisor specializing in helping people migrate - sometimes to avoid high taxes back home. He said he expects such cases to rise “dramatically”. However, under the worldwide tax code operated by the US, any American who wants to renounce citizenship must pay outstanding taxes owed, including capital gains. In a comment subsequently in response to this article, he stated: "If someone decides to pay their long-term CG [capital gains] now while the top federal rate is 23.8 per cent, then they will not have an "exit tax" (which is a capital gains- deemed disposition) if they renounce [citizenship]."