The Big Rich Town is Tiny: Biden’s Tax Proposal and Small Business
Just before the election, 50 Cent’s tweet about the Biden tax plan, which he interpreted as “62% are you out of ya f—mind,” went viral. In terms of reliability for the vast majority of the country’s population – 50 Cent’s net worth is estimated at $30 million – the annual median personal income in the United States is about 0.2% of that – $68,703 and the median net worth of average U.S. households is 0.3 percent of 50 cent’s net worth – at $97,300. Joe Biden’s tax proposals may be similarly impactful.
So, if you are a small business owner, would Biden’s tax proposal’s hurt you or help you? And, if you will be negatively impacted, can you mitigate the detriment? Based on the limited details provided, for the vast majority of small businesses, the tax proposals, to the extent they are likely to be implemented, may not be a detriment, and may even be helpful. Forbes cited The Penn-Wharton group’s analysis of Biden’s tax plan concluding that 80 percent of Biden’s tax increases would impact earners in the top 1 percent. For the small minority of wealthy small businesses, there are sound restructuring, planning, and protection strategies that can significantly limit or even eliminate any negative tax impact. We use the term beneficial to include both from a direct tax impact perspective, as well as from a policy and opportunity perspective.
A quick summary of some of the Biden Tax Proposals are as follows:
- The tax proposal intends to tax capital gains at the ordinary income tax rate of 39.6 percent for income over $1 million.
- The tax proposal seeks to increase the maximum income tax rate from 37% to 39.6%
- The tax proposal is intended to hit households with over $400,000 in Adjusted Gross Income (AGI). Indirectly, it may impact lower wage earners because of reduced investment returns and wages due to corporate tax increases.
- Middle income households may have a $260 increase and high-income households (top 1 percent) may have up to $300,000 increase.
- The tax proposal includes tax cuts for lower-income households, such as tax breaks for renters and first-time home buyers. The proposal also includes a higher Child Tax Credit and introduces a Caregiver Credit.
Business Credits, Retirement, and Itemized Deductions
- The tax proposal may eliminate the Qualified Business Income Deduction (20% deduction generally for non-service small businesses with for taxpayers with an AGI of under $321,400 for married couples and $167,700 for single and head of household. However, based on the goals of impacting households with AGI over $400,000, this may be restructured or instituted differently in order to credit the new administration with the benefit instead of carrying over a potential benefit from the previous administration.
- Limit itemized deductions to those in tax brackets of at or under 28%.
- Flat retirement contribution determined by a specific percentage (which would encourage contributions by taxpayers in lower tax brackets)
Estate and Gift Tax
- Elimination of step-up in basis on inheritances which allows beneficiaries to acquire basis on inherited assets set at the fair market value of the asset at the decedent’s death. This significantly lowers capital gains on sale.
- Reset the exclusion amount for estate and gift tax to $5 million, adjusted for inflation, instead of the 10 million, adjusted for inflation.
Explaining the potential changes and scope of impact:
Income Tax Bracket Rate Changes:
First, increasing the 37% highest income tax bracket to 39.6% is not unanticipated under the current laws. Most the 2017 TCJA tax cuts expire in 2026. Biden’s tax proposal for the most part eliminates the temporary tax cut period. Second, adjusted Gross Income or AGI for self-employed, that is, Schedule C business owners, is business income less expenses and deductions, and generally minus adjustments. This means, that most self-employed businesses, including single member LLC’s will likely be nowhere near the $400,000 threshold (also, over 86% of small business owners make under $100,000 a year in income). Second, the remaining majority of small businesses, LLCs, partnerships and S Corporations generally do not distribute significant income on Schedule K or as dividends, again making the $400,000 threshold unlikely.
What should you do now?
If you are small business owner, regardless of your business or personal income, this is a good time to consult with a tax law attorney to ensure your business is structured properly (LLC versus LLP versus S Corp versus C Corp, for example) to minimize your taxable income and reduce the Adjusted Gross Income attributed to you directly, which may subject you to a higher tax bracket. These are planning and strategy considerations that should be addressed before starting, during growth and expansion, and changes to a business regardless of tax law changes.
Capital Gains Tax Changes:
The increased tax on capital tax is only applicable for high income households. Generally, most high-income taxpayers have instituted significant tax planning such that through proper structuring capital gains are either shifted or eliminated in any given tax year. Implementing the proposals will only require implementing the more aggressive strategies in investment allocation, transfer tax planning, gifting, and trust funding more common prior to the 2017 TCJA, and using some of techniques prevalent in the years preceding the Great Recession of 2008. This may include using charitable trusts (CLT, CRT), grantor trusts (GRAT), year-end gifting, business restructuring, asset allocation and investment allocations, among other planning strategies.
What should you do now?
Even if you are not a business owner with significant investments subject to a higher capital gains tax rate, now is an opportune time to consult with a financial advisor and a tax attorney to determine optimum ways to maximize return on assets and consider passive sources of income in the long term. Additionally, trusts, such as Grantor Retained Annuity Trusts or Charitable Lead Trusts may be useful to maximize the low interest rates and transfer opportunities and “freeze” values of certain assets which would otherwise be subject to negative tax implications.
Qualified Business Income Deduction Changes
The Qualified Business Income Deduction is unlikely to be truly eliminated. Based on the Biden tax plan’s goals of further taxing households with AGI over $400,000, this may be restructured or instituted differently in order to credit the new administration with the benefit for households under that threshold with qualifying businesses, instead of carrying over a potential benefit from the previous administration.
What should you do now?
The QBI deduction does not apply to many service based and consulting businesses even now. Even if this deduction is eliminated, it is unlikely to impact many growing small businesses as a result. However, consulting with a tax attorney and an accountant on maximizing deductions using restructuring of the business or transferring business interests in conjunction with estate planning and business succession planning is likely to mitigate and may even provide greater benefits to many small businesses than the QBI deduction.
Itemized Deduction Limitations
The itemized deduction being capped to eliminate the deduction from applying to high-income earners is predominantly on mortgage deduction, charitable contributions, medical expenses, and state and local taxes. These tax favorable impact is generally structured and planned on assets for high-income earners through charitable trust planning, and structuring loans to be an asset growth vehicle. This item will only increase the planning strategies employed to a larger number of transactions and high-income earners but would not remove benefits for the vast majority of taxpayers.
What should you do now
Note that the tax proposals include several credits and deductions previously unavailable or limited. The goal here for small business owners should be to reduce their individual tax bracket to qualify for the greatest number of credits and deductions and using strategies such as transferring wealth and assets through business succession and estate planning to further these goals (for example, income from certain investment assets may not be allocated to the individual). Additionally, the itemized deductions are not the primary asset growth vehicle for the high-net worth taxpayers with proper planning. For the small business owner in the 99% of taxpayers, this is an opportune time to purchase a home (taking advantage of the low financing rates), consider their philanthropic goals and manage investment allocations to maximize these deduction. Consulting with financial advisor and a tax planning attorney would provide a wide range of strategies and options to maximize itemized deductions even for the business owner who may seem to not qualify at first glance.
Retirement Planning Changes
Elimination of the retirement plan funding at higher tax brackets would also encourage using the trust funding and lifetime wealth transfer strategies to mitigate. But, for lower and middle class families, the increased deduction would encourage retirement planning and it can be coupled with small business income and allocating more income to tax-deferral strategies by employing retirement strategies in the small business structure.
What should you do now?
As with most of the tax proposals, the retirement plan funding changes proposed also highlight the need for tax planning and business succession planning. For many small business owners falling within the middle to low income family income classes, it is an opportune time to consider incorporating retirement planning as an asset and investment strategy even as part of the business. It is usually a viable strategy to benefit from the tax deferrals on the income funding retirement plans. For high income business owners, this change, if implemented, merely causes a shift in the myriad strategies in asset protection and makes vehicles such as trust funding and lifetime wealth transfers through planned gifting and charitable planning more attractive. Any of these strategies have varying levels of benefit for each business owner and the combination of applicable strategies should ideally be determined and implemented in consultation with a tax attorney, financial advisor, and an accountant.
Estate Tax Changes
The elimination of the step-up in basis would subject inheritances to capital gains tax without allowing multiple generations of wealth to eliminate the tax on gains through inheritances and structured planning. This does not remove the high-income taxpayers’ ability to engage in sophisticated planning techniques, including lifetime gifting, transferring interests or assets (at least on paper) through various instruments, including trusts, to prevent the additional implication of the elimination of the tax. Certain assets are “saved” for the estates merely to benefit from the step-up and removing that fact is unlikely to impact the vast majority of taxpayers. For small businesses, investments and reinvestment’s are made in the business growth and in revenue generation rather than to fund inter-generational wealth under the title of small business for engaging in passive investment activity. As a result, small businesses can engage in more sophisticated planning and may have more income as a result of additional favorable deductions to further plan towards an inter-generational wealth transfer model for their families.
Finally, reducing the exclusion amount to $5 million adjusted for inflation does not necessarily change the realm of estate planning today. The increased exclusion amount was set to expire in 2026 even under the existing 2017 TCJA. Thus, the timeline for implementing strategies such as lifetime gifting or transfers to trusts is only accelerated for the most part.
What should you do now?
Now is the time for small businesses at all revenue levels to consult with an estate planning and business succession planning attorney. The level of sophisticated strategies to transfer wealth during life, whether in the business interests while retaining control, or through a series of trusts and direct gifting will depend on the income and net worth levels of the individual taxpayers. However, there are ample strategies and tools that the elimination of the step-up would not necessarily be significant negative impact. Additionally, this also highlights the need for life insurance as a cash vehicle to fund liabilities including tax, without depleting the estate assets and business interests. Life insurance can be funded through dynasty and other irrevocable trusts to minimize inclusion in the estate while maximizing the funds available to pay off any direct and ancillary liabilities. An experience tax attorney can guide the taxpayer through the specific strategies and cash flow requirements needed to properly plan to reduce any negative impact of the elimination of a step-up in basis or a reduction in the exclusion amount.
The above is merely a general overview of the general scope and impact of potential tax law changes under a Biden presidency. As a general matter, most of the proposals are not unfamiliar and either re-institute existing laws without the temporary changes implemented by the 2017 TCJA or introduce aspects from tax laws existing from prior years. There are existing and modified tax planning strategies to benefit most small businesses if implemented properly. The Royal Law Firm PLLC provides tax planning and strategy to business owners at all stages and at all levels with a scaling approach towards devising and implementing the strategy. To learn more, please contact us.