A few weeks ago, President Biden introduced proposed legislation under the name of the “American Families Plan” (“AFP.”) In this month’s update, I wish to summarize the appropriateness, or perhaps the double-meaning, of the name of the American Family Plan legislation. If the AFP is enacted, certain taxpayers should consider gifts to other members of the taxpayer’s family, or perhaps gifts to favorite charities, thereby benefitting other American families. There are many uncertainties about the AFP proposal, including the opportunities that wealthy taxpayers might have to liquidate highly-appreciated assets ahead of the effective date of any legislation. For now, I wish to draw your attention to how two tax proposals, if enacted, would impact gifting decisions.
- Capital Gains Rates
First, wealthy taxpayers would see a significant increase in capital gains tax rates. Currently, capital gains tax rates for Minnesota residents are as follows:
Taxable Income: Federal Tax Rates: Minnesota Tax Rates:
Less than $40,000 0% 5.35%
$40,000 to $441,450 15% 7.05% to 9.85%
More than $441,450 20% (plus 3.8% NIIT, if applicable) 9.85%
Under the AFP, the highest ordinary income tax rate and capital gains tax rate would increase to 39.6%. Among the subset of these earners who earn more than $1.0 million per year, the AFP would increase the long-term capital gains tax rate to 39.6%, and also continue to apply the 3.8% net investment income tax (“NIIT”). In total, these high income-earners would pay a federal tax rate of 43.4%, in addition to the Minnesota rate of 9.85%.
- Phase Out of “Step Up” in Cost Basis at Death
Second, the AFP would phase out the benefit of the “step up” in cost basis for some families. Traditionally, the cost basis for all appreciated assets is “stepped up” to the fair market value of the asset as of the date of the owner’s death. Under the AFP, the surviving family members of a deceased taxpayer would have the right to “step up” appreciated assets, but the amount of this “step-up” would be limited to $1.0 million per person. This amount would be in addition to the $250,000 exclusion from capital gains for the sale of a primary residence. It is not clear from the White House press release whether the appreciation in excess of the $1.0 million threshold would trigger an immediate taxable event at death (similar to an estate tax liability), or only require the beneficiaries of the assets to receive the assets with a carry-over basis. Also, the press release mentions, but does not provide specifics about, the possibility of exclusions for family-owned businesses and farms.
If AFP is enacted, there are two groups of beneficiaries who would benefit from the legislation.
- Gifts for the Benefit of Children:
First, adult children would benefit from additional lifetime gifts of highly-appreciated assets. These gifts could be made either directly to adult children, or to trust(s) for the benefit of children and grandchildren. Two important tax benefits follow from such gifts. First, if the adult children are at a lower tax bracket than the current owner, the family would collectively pay a lower capital gains rate upon sale. Second, the lifetime gift would have the effect of lowering federal estate tax and Minnesota estate liability at death. Lifetime gifts “lock in” the value of the at current value so that all subsequent appreciation in the value of the gifted asset(s) will pass free of federal and state estate taxes. In addition to this benefit, if a Minnesota resident lives three years past the date of the gift, the entire gifted asset passes free of Minnesota estate taxes. Under current law, by reason of an unlimited step-up in cost basis at death, owners of highly-appreciated assets would have a sound tax reason owning, and not gifting, highly-appreciated assets. However, if legislation is enacted that limits the benefit of the step-up in cost basis, no such countervailing tax benefit would exist. Therefore, if AFP is enacted, we are likely to see an increase in gifting strategies to children or to irrevocable trusts for their benefit.
- Gifts for the Benefit of Charity:
Second, public charities should see an increase in the number of gifts of highly-appreciated assets. These gifts could take the form of gifts directly to public charities, gifts to such charities through a client’s donor advised fund, or perhaps gifts through “split interest” irrevocable charitable trusts such as charitable remainder trusts or charitable lead trusts. Depending upon the structure of the charitable gift, a taxpayer may be able to not only avoid the capital gains tax that would otherwise be associated with the sale of the asset, but also obtain an income tax deduction for charitable contribution.
It is worth reminding our clients that charitable gifts are appropriate if clients have non-tax reasons for charitable gifting. Congress and the IRS have created the tax code so that, even with respect to irrevocable split-interest charitable trusts, there is no way in which a taxpayer can “get ahead” from a purely quantitative cost-benefit perspective. By way of example, if clients create a charitable remainder trust, the annuity or unitrust payments made back to the taxpayer during the initial term will be subject to income taxes or capital gains taxes, depending upon the tax characteristics of the assets contributed to charitable remainder trust. In these types of matters, a careful and thorough dialogue with our mutual clients is of critical importance.
Many families will not be impacted by the American Families Plan, if enacted. However, every potential gifting strategy should be carefully considered with a client’s advisory team on a case-by-case, customized approach, taking into account the factors unique to each client’s family.