Taxes

Congressional Committee Issues Late-Night Tax Proposal

On September 13th at 11:20 pm Eastern time, House Ways and Means Committee Chairman Richard Neal (D-Mass.) released long-awaited details on Democrats’ proposed funding for the $3.5 trillion American Families Plan. The House’s tax plan differs from President Biden’s in many respects and includes some pleasant—and unpleasant—surprises.

Investors should not panic. The House proposal is the first pitch of a nine-inning game, one that is likely to produce many twists and turns. Some—and perhaps many—of the House proposals will not be enacted. The most important takeaway from the House proposal? Estate and gift tax laws now appear likely to change, perhaps dramatically. Those who have postponed implementation of lifetime wealth transfer strategies should execute those plans as soon as possible. It’s not clear whether proposed changes in the House bill will become law, but one thing is certain: Future tax laws are unlikely to become more favorable than they are right now. Investors who can afford to act should act now.

Things to think for now:

If a client has any plans to transfer wealth to a grantor trust (IDGT, SLAT, GRAT), then they should do so immediately. That must be completed before the new law is enacted, as these tax shelters would become part of the estate again, and subject to taxes.

QSBS owners wouldn’t be 100% tax-free, and they would have to pay taxes on 50% of their shares. The change in the exclusion would be retroactive to Sept. 14, but if they had plans to gift it to a non-grantor trust, they can still do that in the future.
Proposed is a cut in the per-person estate tax exemption to roughly $6 million from $11.7 million. For married couples, the exemption drops to just above $12 million from $23.4 million. This becomes effective January 1, 2022, so if they plan to gift more than $6 million, they should do so before year-end.

The top capital-gains tax rate is bumped to 25% from 20%. If passed, the increase would apply to all transactions completed after Sept. 13, 2021. Unless the proposed legislation changes, it’s too late to sell and realize capital gains under today’s lower rates. I suppose since the marginal income tax rate is increasing from 37% to 39.6% (effective 1/1/22) plus a 3% surcharge on income over $5 million (effective 1/1/22), a client might consider looking for opportunities to accelerate income from 2022 into 2021.

The discussion below focuses on those elements of the House plan that are likely to have the greatest impact on individual investors, if enacted.

Key income tax proposals:

The top corporate income tax rate would increase from 21% to 26.5%, effective in 2022.
Under current law, 100% of up to $10 million of gain from the sale of qualified small business stock (QSBS) may be excluded from gross income. The House proposal would slice that exclusion to 50% for most QSBS shareholders, effective immediately.
The top marginal income tax rate would increase from 37% to 39.6%, effective in 2022, for married couples filing jointly with taxable income of more than $450,000, individuals with taxable income of more than $400,000, and trusts and estates with taxable income of more than $12,500. An additional 3% surcharge would apply to modified adjusted gross income of more than $5 million for married couples filing jointly, $2.5 million for individuals, and $100,000 for an estate or trust, effective in 2022. Including the new 39.6% rate, the new 3% surcharge, and the current 3.8% surtax on net investment income, the highest marginal federal rate would climb to 46.4% under the House proposal.
The long-term capital gain tax rate would increase from 20% to 25%, effective immediately, for married couples filing jointly with taxable income of more than $450,000, individuals with taxable income of more than $400,000, and trusts and estates with taxable income of more than $12,500. Including the new 25% rate, the new 3% surcharge, and the current 3.8% surtax on net investment income, the highest marginal long-term capital gain tax rate would rise to 31.8% under the House proposal.
Under current law, the 3.8% surtax on net investment income applies only to passive income. The House proposal would add active trade or business income, effective in 2022, for married couples filing jointly with more than $500,000 of taxable income, and individuals having more than $400,000 of taxable income.

Key transfer tax and related proposals:

Under current law, the gift and estate tax exclusion sits at $11.7 million per person; the House proposal would halve that amount to about $6 million (inflation-adjusted), effective in 2022—accelerating a reduction that is set to occur in 2026.
Assets held in grantor trusts will be included in the grantor’s estate for estate tax purposes. Any distribution from such a trust during the grantor’s life would be treated as a gift for gift tax purposes. Any sale of assets to such a trust will be treated as a sale to a third party, and thus subject to income tax on any gain. Each provision would apply to (i) trusts created on or after the date of enactment (i.e., when the President signs the legislation), and (ii) to any portion of a trust established before the date of enactment which is attributable to a contribution made on or after the date of enactment.
Transfer tax valuation discounts for nonbusiness assets would be disallowed, effective for transfers after the date of enactment.

Key individual retirement account (IRA) and qualified plan proposals:

No additional contributions may be made to Roth or traditional IRAs if total IRA and defined contribution plan balances (“combined balance”) exceed $10 million. Accelerated distributions would be required for combined balances exceeding $10 million. Each provision would take effect in 2022.
An IRA holding any private placement security (e.g., an investment that is available only to qualified purchasers or accredited investors) would forfeit IRA status, effective in 2022, subject to a two-year transition period for IRAs already holding such investments.

Not included in the House proposal:

Repeal of the “step-up” in basis at death
Deemed recognition of capital gain at death
Repeal of the current $10,000 limit on the deductibility of state and local taxes (SALT)
Limitations on Section 1031 exchanges

The House proposal represents the first real indication of how Congress may fund the $3.5 trillion American Families Plan. Assuming Democrats find common ground, at least some of the proposed tax law changes are likely to stick. In that spirit, certain tax planning opportunities emerge:

Investors who have been considering large gifts of up to the $11.7 million basic exclusion amount—especially gifts that would involve a valuation discount for nonbusiness assets—should finalize those transfers prior to the end of 2021. Transfers to irrevocable (“intentionally defective”) trusts may have an even shorter timeframe, as restrictions on grantor trusts would become effective as of the date the President signs the legislation. Attorneys and appraisers are already extremely busy so prompt attention to pending transfers is essential.
Owners of QSBS should consider using multiple layers of exclusions (commonly referred to as “stacking”) to maximize the avoidance of gain under a reduced 50% exclusion.
Consider early withdrawals from IRAs and qualified plans, and exercising nonqualified stock options at lower marginal rates today to avoid a “force-out” of assets at higher rates beginning next year.
Qualified purchasers and accredited investors should consider investing in certain alternatives through low-cost, “private placement” life insurance (PPLI) policies, as new investments through an IRA may become prohibited. If structured properly, investment growth within such a policy should avoid current income taxation. The proposed 5% increase in the long-term capital gain tax rate, and the 3% surcharge for those expecting more than $5 million in income, make investing through PPLI even more appealing.

We will continue to monitor the progress of any tax legislation and keep you informed. As always, we are eager to work with your tax professionals to answer any questions and develop a plan that fits your individual circumstances.

For illustrative purposes only; and does not constitute an endorsement of any particular wealth transfer strategy. Bernstein does not provide legal or tax advice. Consult with competent professionals in these areas before making any decisions.

Please reach out to Troy if you have further questions or a client who might want to discuss this further. https://www.bernstein.com/our-team/locations/seattle/troy-niehaus.html

Contributed by Troy Niehaus

A Safety Net for your 1031 Exchange

One of the great tax deferral options in the world of real estate sales is the 1031 Exchange.

The 1031 Exchange allows the real estate seller to defer their capital gains tax, by exchanging their property for another like property. As with all the many IRS tax deferral programs, certain requirements must be met.

However, real estate sellers looking to complete a time-sensitive 1031 Exchange, have sometimes found themselves in a challenging situation. They may be running out of time, unable to negotiate a reasonable financial transaction or other issues associated with real estate transactions.

If a seller is concerned that their 1031 Exchange could face problems, they could always choose to utilize another tax deferral option. One excellent example is IRS(C) 453(A) Installment Sale with a monetization feature.

With this tax deferral program, the seller receives their money at closing in a tax-free form, while deferring their capital gains tax for 30 years. The challenge is that the 1031 exchange and the 453(A) Installment Sale are two different tax-deferral options. Each having its own rules and regulations.

However, if you work with an experienced ‘Exchange Facilitator / Designated Intermediary’ you can build a safety net by using both deferrals in the same transaction. In addition to protecting against a failing 1031 exchange, there are other financial reasons where the seller can benefit from utilizing both a 1031 Exchange and a 453(A) Installment in the same transaction.

When would Combining IRC 1031 Exchange & IRC 453(A) Installment Sale?

When you fear that your 1031 Exchange might not work out as planned.
In cases where a replacement property covered only a portion of your sales proceeds.
In cases where you want a new property but also needed cash for other uses.

Examples of combining tax deferral options:

Seller receives $5,000,000. taxable dollars from their sale and begins the 1031 exchange.

Seller finds a desirable replacement property for $3,500,000 utilizes the 1031 exchange. The seller is then unable to find an appropriate property for the remaining $1,500,000. Using an experienced exchange facilitator, the seller then defers the remaining $1,500,000. Using a 453(A). The seller receives the remaining funds in a tax-free form and defers the tax for 30 years. The seller can now use the $1,500,000. to buy any property they desire with none of the 1031 exchange restrictions.
The seller is interested in using some of the $5,000,000. of the sold property to exchange for another property. However, the seller also needs $2,000,000. in cash, to pay for other debts and alternative investment opportunities. The seller starts with the 1031 exchange process. They find an appropriate replacement property for $3,000,000. and utilize the 1031 exchange. Using an experienced exchange facilitator, they then transfer the remaining $2,00,000. to a 453(A). The seller receives this money in a tax-free form, defers the tax for 30 years, and invests the money as needed.

What are the important keys in utilizing two options for one sales transaction?

You always start with the implementation of a 1031 Exchange.
You need to utilize an exchange facilitator who has experience with both 1031 & 453.
The minimum dollars necessary for the 453(A) implementation is $500,000.
Utilize a coordinator who is experienced implementing a 453(A) Tax Deferral.

Contributed by Jack Gruber

The Art of Deferring Taxes in a Sale

When you sell real estate, your business, a patent, or stock in a privately held company, capital gains tax will play a significant role.

Depending on the state in which the asset is sold, the tax can vary dramatically. As an example, assets sold in Washington will have a base tax of 23.8%. In Oregon, the base is 33.7%, in California, the base is 37.1%.

The good news is that the IRS allows for alternatives when addressing your capital gains tax obligation. You have two basic choices. You can pay the tax in the year of the sale, or you can defer the tax to some future tax period.

There are over a dozen different deferral options listed in the 70 thousand pages of tax code. Many people who have sold or bought investment real estate are familiar with the deferral option known as IRC 1031 Exchange.
This is an excellent option for real estate sellers who are interested in acquiring another piece of real estate. In simple terms, it allows the seller to defer their tax by transferring their ownership to another property. In turn, the seller can defer the tax obligation to a future date.

However, IRC 1031 Exchange, is only available for real estate transactions. How do you defer your tax if what you are selling is not real estate? One of the other tax-deferral options might be the answer.

As an example, people selling a business, patent, or private stock sale often utilize IRC 453 & 453(A) Installment Sale with Monetization Loan. This deferral option will also work for a real estate sale where the seller does not want another property but would like to defer the capital gains tax.

I am often asked which deferral option is best? The answer to that question is dependent on the seller. What is the goal of the seller, along with the math and structure of the sale itself? Every deferral option has a value under the right circumstances.

Because many CPAs, financial planners, and tax professionals, have limited familiarity with the IRC 453 & 453(A) the following is a basic outline of that option.

The most important thing for a seller is information. The more they know about their deferral options the better equipped they are to make an informed financial decision.

(IRC) 453(A) Installment Sale with Monetization Loan
The correct implementation of IRC 453 allows the asset seller to receive their money in a tax-free loan at closing, while deferring their capital gains tax obligation for 30 years.

Utilize a Qualified Intermediary (QI) the same as a Facilitator in a 1031 Exchange.

Asset Types to be sold: Real Estate, Business, Intellectual Property (patents), Private Stock Sales.

Loan Type: Uncollateralized, limited recourse, 30 years in length. P&I payments come from the QI, not the seller.

Seller Protection: Seller is protected from actions or financial failures of either the QI or Lender.

Use of Loan Proceeds: Seller (Loan Recipient) can invest the proceeds in a fashion they deem appropriate.

Value of a Tax deferral: The financial value comes from the basic ‘Time Value of Money’.

Example: Assume an asset sale resulting in a $1 million tax debt. Seller could pay the IRS $1 million, or invest the $1 million for 30 years then pay the tax.

If Seller dies before the end of 30 yr. deferral. The deferral continues. The beneficiaries pay the tax in 30 years and reap the rewards of the investment.

If IRC 453 & 453(A) or another deferral option might help you accomplish your goals, please contact us. We focus exclusively on capital gains tax issues.

Contributed by Jack Gruber

Tax Options on The Sale of Your Business or Real Estate

When you sell an asset, you have two basic options for dealing with any tax obligation: ‘Pay the tax’ or ‘Defer the tax’.

You must then determine which of the options best fits your needs?

Cash Sale – The seller pays the tax in the year that the sale was completed.
IRC 1031 Exchange; IRC 1033 Exchange – The seller defers tax obligation through the exchange of property. The exchange uses a Qualified Intermediary (QI). ALTERNATIVE; Delaware Statutory Trust (DST)
IRC 453 Installment Sale <$5mm; IRC 453(A) Installment Sale >$5mm – Taxes are due in the tax year money is received. ALTERNATIVE; Deferred Sales Trust (DST)
IRC 453/453(A) Installment Sale Followed by a Cash Option – Seller receives tax free limited recourse loan, invests tax dollars and defers tax for up to 30 years.
IRC 1400Z 1&2: Economic Opportunity Zones (OZ) (Utilizes some Exchange rules) – Investors receive deferral opportunities by investing into government designates areas needing revitalization. There are varying time frames for the deferral opportunities.

The most important thing you can do for yourself and your estate is to be aware of your options and understand how each will affect your financial situation long term. Your specific situation will determine which choice best suits your needs.

For the remainder of this article, we are going to focus on the concept of ‘Tax Deferral’ and specifically the ‘Installment Sale followed by a Cash Option’. Even though this option was created almost forty years ago by Congress in the early 1980’s, most individuals and practitioners are unaware of its existence and the potential value it provides the seller of an asset.

To appreciate the value and purpose of an ‘Installment Sale followed by a Cash Option’ or in fact any “deferral” program you need to start with a fundamental question. “WHY”? Why does the Federal Government allow the deferral of tax obligations in the first place? The answers are relatively simple.

Assets such as business’s or investment property like people have a practical life cycle. Think of it in stages.

The entrepreneur’s idea starts to develop a business or property. It grows, expands, matures, and finally, its growth trajectory begins to flatten. Age, technological advancement, and consumer behavior all help to sponsor a slow decline.

Over time Congress began to realize that refurbishing and replacing of old assets with the new and modern assets had a positive benefit. Old businesses and property could make way for new more prosperous opportunities. This advancement could result in more jobs, stronger tax bases, and overall economic expansion.

While this created a positive effect on the economy, asset owners were often hesitant to sell because of the potential associated tax liability. As a solution, Congress began to create opportunities to defer the tax obligation. It has never been Congresses intent to void the tax obligation rather they provide techniques to defer. This approach allows new development and advancement to take place while collecting the tax obligation in a manner more favorable to the seller.

Congress’s decision to create the “Installment Sale followed by a Cash Option” was a combination of desired economic expansion along with the need to temper a state of economic chaos. It was the early 1980’s when interest rates were topping out of their thirty-year climb. Certificates of Deposit (CD’s) were yielding 15%. ‘AAA’ to ‘A’ rated bonds held coupon rates of 18% to 21%. This coupled with high unemployment, and high inflation produced the economic phenomena known as ‘stagflation’. The economic turmoil became so significant that an economist by the name of Arthur Okun created the ‘misery index’.

The structure of the ‘Installment Sale followed by the Cash Option’ was born out of this chaos. Its structure is elegantly simple. It consists of two basic parts. The first is the ‘Installment Sale”. The idea of an ‘Installment Sale’ is some of the oldest Internal Revenue Code (453), dating back to 1913.

The basic principle of the ‘installment sale’ is that the seller owes tax on the proceeds of the sale as they receive the money. As an example, if the seller receives the proceeds of the sale divided equally over the next five years, then they will owe tax on just 20% of the proceeds each year. If they choose to receive a lump sum distribution at some date in the future, then that will be the year the taxes are due. There is no limit to how long the installment may last, and there is no limit to the configuration of the time frame. The one constant is that the tax is due on the money that the seller receives, in the year they receive it.

In the case of the ‘Installment Sale followed by a Cash Option’ a ‘Qualified Intermediary’ (QI), is used in the same fashion as a QI is used in an IRC 1031 Exchange. The QI acts as a legal barrier between the seller and the proceeds of the sale. This allows the seller to determine when and in what configuration the sale proceeds will be received and the year the resulting tax will be owed.

Once the ‘Installment Sale’ is completed then the seller can choose how they wish to receive the money from the sale. Rather than directly receiving the sales proceeds which would trigger the tax obligation, the seller can take the money in the form of an uncollateralized, tax-free loan. Interest and principal on the loan will come from the sales proceeds held by the QI, not from the seller.

This structure provides the seller the opportunity to receive money, invest the proceeds, and ultimately have all interest and principal payments made from the sales money held by the QI. The ability to institute these two steps, the ‘Installment Sale’ and the ‘Cash Option’ produces the quintessential ‘Time Value of Money’ equation.

It is important to understand that the ‘Installment Sale’ and the ‘Cash Option’ are NOT interdependent. They are totally separate and independent functions. A seller can choose to do one or the other, both or neither.

If the seller of an asset chooses to institute a ‘Cash Option’ the ‘Time Value of Money’ leverage can provide a significant financial benefit. As a simple example, let’s assume the potential tax obligation for an asset sale was $1,000,000.

The seller could either pay the $1,000,000. in the year of the sale or defer and invest the $1,000,000. for an extended number of years by receiving their assets in the form of a tax-free loan.

If the seller invested the $1,000,000. at a 6% net return for say 30 years, the tax dollars would grow by approximately 5.74 times. At the end of 30 years, take the resulting $5,740,000. pay the $1,000,000. tax bill and increase the value of the seller’s estate by approximately $4,740,000. Just by deferring the tax obligation.

As the seller of an asset, the most important lesson to be learned is that there are options. No option, be it a 1031 exchange or a 453(A) Installment Sale coupled with a Cash Option fits every situation. If you understand your options, you are better equipped with the information necessary to make an informed intelligent decision.

Contributed by Jack Gruber

When Your 1031 Exchange is in Trouble

One of the great government programs in the world of real estate transactions is the 1031 Exchange. This IRS tax deferral option was put into effect in 1921.

The Exchange allows the real estate seller to defer their capital gains tax, by exchanging their depreciated property for another like property. As with all the dozen-plus IRS deferral programs, certain requirements must be met. In normal market conditions, the 1031 Exchange regulations require focus and understanding, but they are manageable.

When the market conditions are not ‘normal’, reasonable regulations can become problematic. In today’s market, we have an environment that can be challenging. Limited inventory, rapid economic expansion, and seller driven pricing.

Starting in February/March, we added COVID-19 into the economic mix. This pandemic has created an economic, overnight, shutdown, and rapidly growing unemployment. The first-quarter GDP shrank -4.8%. Expectations are that this number will decline even further with economic revisions.

Many real estate sellers looking to complete a time-sensitive 1031 Exchange, can find themselves in a challenging situation. Fortunately, IRS deferral programs provide alternative deferral options that can be advantageous in the current market conditions.

One excellent example is IRS(C) 453(A) Installment Sale with a Tax-Free non-recourse loan. With this deferral program, the seller receives their money at closing, while deferring their capital gains tax for 30 years.

With the 453(A) the seller is then able to buy any property or investment they choose, without the time limits or like property restrictions of the 1031 Exchange.

The key for real estate sellers is to understand that they have options. In a world of uncertainty, a hurried transaction can be costly. This market will ultimately create significant buying opportunities. Avoid making a rash buying decision because of artificial time restrictions. You have options.

If you would like a more thorough understanding of the Capital Gains Tax Deferral options available to you, simply contact me. In this day of social distancing, it may have to be a phone or ZOOM meeting. Please feel free to include your CPA or Tax Attorney in our discussions.

Contributed by Jack Gruber

Should Tariffs Hurt Your Customers?

Recently I’ve had a number of discussions with company owners and other consultants about Trump’s tariffs. Many companies are wringing their hands due to the sharply increased costs on many commodities associated with the 25% tariffs, and in some cases, the lack of availability of materials. Do these tariffs need to have that big an impact on your company or your customers?

A recent editorial in the Wall Street Journal (My Customers Don’t Pay Trump’s Tariffs – July 1, 2019 p A17), shared the experience of the CEO of a consumer-electronics company that sources 90% of their products from China. Even though his products should have a 25% tariff, the company only experienced a 2% cost increase. How can that be? His purchasing department took a proactive partnership approach to his Chinese suppliers, appealing to their best interests, and got price concessions that all but wiped out the impact of the tariffs.

There are three key elements you can use to mitigate the impact of tariffs on you and your customers:

Don’t use your buyers for buying! – They should be much more than order executers, they should be managing the supplier relationship.
Focus on Total Cost Of Ownership – It includes many costs not considered during product development and off-shoring activities.
Develop partnerships with suppliers – Focus on a few carefully selected suppliers for speed, quality improvement and cost reduction.

A strong supply chain strategy is vital to reduce or even eliminate the impact of the current tariff environment. If you would like a review of your Supply Chain Strategy, give me a call.

Contributed by Rick Pay