Biden Targets HNW Citizens' Tax "Loopholes" - Wealth Industry Reacts

Tom Burroughes Group Editor April 30, 2021

Biden Targets HNW Citizens' Tax

Confirming leaks last week, the US administration is raising income and capital gains taxes on the wealthy, resulting in a federal CGT rate that - if the proposals are accepted - would be double the top rate paid in Canada or in the UK.

The US administration is squeezing high net worth investors on a number of fronts, confirming wealth advisors’ concerns that tax hikes on capital gains, income and inheritances are on the way. 

The Joe Biden administration said it wants to end “loopholes” such as lower capital gains taxes that “reward wealth over work,” a move that it claimed will raise more than $1.5 trillion over a decade. When leaked in part to the media last week, the proposals hit the stock market.

In its American Families Plan, the government said that HNW citizens had been able to exploit weak revenue enforcement, citing studies showing that people on the highest incomes can benefit from misreporting rates of up to 55 per cent. The top “one per cent” of earners fail to report 20 per cent of income and did not pay $175 billion in taxes owed, it said. 

“We have a two-tiered system of tax administration in this country: regular workers pay the taxes they owe on wages and salaries while some wealthy taxpayers aggressively plan to avoid the tax laws,” the document, issued April 28, said. 

The tone of the proposals, referring to lower taxes on capital and dividends as “loopholes”, arguably justifies fears that wealth managers have had that the Biden government, working with a Democrat-led Congress, is hitting the wealthy with higher taxes on income, capital and inheritance. As reported this week, if federal CGT rates are doubled, for example, then when state taxes are added, HNW investors living in states such as California and New York – important wealth management hubs – face rates nearing 60 per cent. (By comparison, the top CGT rate in the UK and Canada is 20 per cent.)

“As proposed, the American Families Plan may have multiple impacts on the planning for owners of family businesses who may be forced to make a `now-or-never’ decision on the future of their business. In particular, the interplay of increased capital gains rates and eliminating the basis step-up at death [might] lead business owners to ponder a fundamental question,” Timothy Laffey, head of tax policy and research at Rockefeller Capital Management, said in a note. “Should they exit the business under the current favorable capital gains regime or update their business succession plan to ensure their heirs continue to run the business in perpetuity to avoid the tax implications of eliminating the stepped-up basis upon the owner’s passing? Certain carve-outs are mentioned in the press release (farms, operating businesses), but effective planning will depend on the unknown nuances of actual legislation.”

“What may be more notable, however, is what is not included in the plan. Specifically excluded from the American Families Plan are any changes to the transfer tax regimes (estate, gift and generation-skipping transfer taxes) similar to what was proposed by Senator Bernie Sanders in his `For the 99.5 per cent Act.'  One is left to wonder if this was a strategic plan by the Biden Administration for negotiation purposes, or if overhauling the transfer tax regimes will not be a priority of the administration?” Laffey said.

Under the Trump administration, estate tax thresholds were doubled while, in a controversial move, the ability to deduct state and local income taxes from federal rates were limited, hitting traditional strong Democrat states on the coasts.

The Biden administration said that its tax hikes on wealthy citizens, in combination with its corporate tax changes, would mean that all of its “investments” would be paid for during the next 15 years.

“President Biden’s proposed 39.6 per cent rate on long-term capital gains is punitive and likely sub-optimal,” Jack Balin, chief investment officer at Cresset, the US wealth management house, said. “Congress’ Joint Committee on Taxation calculated the revenue-maximizing capital gains rate at 28 per cent. We therefore conclude it is designed to punish the wealthy, even if that means leaving tax revenue on the table.”

“This is an opening salvo: we expect the agreed rate to settle around 28 per cent, halfway between the current 20 per cent and the 39.6 per cent rate under consideration. On top of this the current 3.8 per cent tax on investment income that funds the Affordable Care Act would still be applied. We could also possibly see the tax rate on dividends raised to 28 per cent from its current 20 per cent rate, although we haven’t heard talk of that yet,” he said. 

Ablin continued: “Despite the dire warnings, we believe the market impact of a higher capital gains rate would be minimal since only about one-quarter of today’s equity market holders are subject to capital gains taxes. That’s because 40 per cent of US equity holders are foreign and another 30 per cent are tax-exempt pension funds and retirement accounts.”

“We believe it is unlikely that affected equity holders would simply cash out to realize gains and then run away from the equity market. Given that the capital gains tax applies to investments of all stripes, from equities to art, affected investors would most likely sell and rebuy similar securities to boost their cost basis. Besides, any significant pullback would be pounced on by opportunistic buyers who are unaffected by the new tax regime,” he said. 

“While many details are still needed, it’s safe to say there will be some type of tax increase, and particularly for HNW [citizens], on the individual income tax rates (both ordinary income and capital gains) for the wealthy,” Alvina Lo, chief wealth strategist, Wilmington Trust, said. "Couple this with the states increasing its taxes on the wealthy (NY being an example just last week), planning is ever more important.”

“We’re talking to clients on actionable strategies with various timeframes – immediate, next 2 weeks (contribution to IRA) and near-term (close examining of portfolio to strategically harvesting gain and losses, Roth IRA conversion),” Lo continued. “Income tax planning will become more important and strategies around managing income threshold level will likely take center stage.”

The administration wants to hike the top rate of income tax to 39.6 per cent, reversing the Trump government’s cut to 37 per cent. The top rate will only apply to those “within the top one per cent,” it said.

Households making $1.0 million or more in earnings, will pay the same 39.6 per cent rate on capital gains as on income, the administration said, arguing that it is unfair for income and capital gains to be taxed at different rates, as at present.

The old “step-up” rule will change, which, the government claimed, allows accumulated gains to be passed across generations untaxed.

“The President’s plan will close this loophole, ending the practice of `stepping-up’ the basis for gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions) and making sure the gains are taxed if the property is not donated to charity. The reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business. Without these changes, billions in capital income would continue to escape taxation entirely,” the document continued.

The administration said that it is urging Congress to close the carried interest “loophole” so that hedge fund partners will pay ordinary income rates on their income. 

“While equalizing tax rates on wages and capital gains will address this disparity, permanently eliminating carried interest is an important structural change that is necessary to ensure that we have a tax code that treats all workers fairly,” it said.

The government also said it wants to end a real estate tax break that allows real estate investors to defer taxation when they exchange property for gains greater than $500,000. 

Cresset's Ablin added: “When President Reagan signed the Tax Reform Act of 1986, he lowered the top income tax rate from 50 per cent to 28 per cent, while raising the capital gains rate to 28 per cent from 15 per cent. When the bill was passed by Congress in October 1986, the news prompted a sharp rise in sales of all capital assets, according to the Tax Policy Center. The S&P 500 plunged 8.3 per cent in September. By December, however, the market had fully recovered. Reagan’s tax package was offset by free market incentives, including a rollback in regulations, the weakening of labor unions and globalization, setting off decades of profit growth which dwarfed labor income gains. That trend peaked in 2011 and has been steadily in retrograde ever since."

"There is little doubt that significant corporate and high-income individual tax hikes will occur, which will likely be a headwind for equity markets," John Vail, chief global strategist at Nikko Asset Management, said. 

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