IS 2021 THE YEAR TO SELL YOUR CAPITAL ASSETS?

I do not typically like to comment on legislation until I’m relatively sure it will become law. The reason for this is that up until tax law is passed both republicans and democrats propose changes. I am taking the time to address a couple of possible provisions being proposed and what can be done by taxpayers.

What are the proposals that are being discussed?

There a few tax provisions that the current administration is discussing. The provisions garnering the most traction are the following:

• Raising the corporate income tax rate from 21% to 35%
• Raising the top income tax rate from 37% to 39.6%
• Elimination of long term capital gains tax rate for taxpayers that earn $1 million or more.
• Elimination of step-up in basis for Estates in excess of $1 million

Raising the corporate tax rate from 21% to 35%

For smaller companies this may mean a shift to S corporation status. Each corporation will need to examine a variety of circumstances. C corporation status, which are the corporations that this tax pertains to, was mainly used by larger corporations not eligible to be S corporations before the Tax Cut and Jobs Act was passed at the end of 2017. When the law passed in 2017 dropping the corporate rate to 21% some smaller businesses did convert to C corporations because the 21% tax rate was lower than the individual income tax rate of the shareholders in many circumstances.

S corporations have been extremely popular because they eliminate the “double taxation” of corporations. If you’ve heard this term before what it refers to is a corporation realizing a profit, paying a tax and the taxpayers also paying a tax when they take money from the corporation. This can best be explained by an example.

Let’s say a corporation finishes the year with a $100,000 profit and pays income tax at the rate of 21%. Also assume that at the end of the year, before the tax payment was made, the corporation had $100,000 in cash. The corporation would pay a tax of $21,000 reducing it’s cash to $79,000. If the corporate shareholder takes this money out of the corporation it will come out in one of two ways. Either the shareholder receives a dividend and pays tax at long term capital gains rates and the corporation receives no deduction or the corporation will pay the shareholder wages and the shareholder must pay income tax, at ordinary income tax rates, Social security tax and Medicare tax as well. The corporation would receive a deduction if wages and payroll taxes were paid.

If the corporation were an S corporation, then the $100,000 would not be taxed at the corporate level but would instead flow to the individual shareholders, thereby eliminating the double taxation. If the shareholders were in the 24% bracket, for example, it would cost $24,000. At first glance it is clear the $24,000 exceeds the $21,000 of the corporation, however once you add the long term capital gains rates (15% to 23.8% depending on income tax bracket) to the $79,000 cash left for the shareholder, the resulting tax is somewhere between $11,850 and $18,802 on top of the $21,000. If the $79,000 were paid as wages the corporation would get a deduction, but the tax would probably still be higher because wages would be subject to Social Security and Medicare taxes and the individual may also be in a higher tax bracket.

There are certain criteria that must be met in order to be an S corporation. One of limiting factors is that an S corporation can have no more than 100 shareholders.

Raising the top individual income tax rate from 37% to 39.6%

This does make taxes exceedingly high, especially if you live in a high tax state like New York, California, or New Jersey. With state tax and the additional 3.8% tax already levied by the Federal government on investment income over $200,000 for those filing as single or head of household, $500,000 for those married filing jointly and $125,000 for those married filing separately, the overall tax rate can exceed 50%.

Elimination of long term capital gains rate for taxpayers earning $1 million or more.

The capital gains rate for these individuals is currently 20% and, as mentioned earlier, there is also a 3.8% investment tax on these individuals. The end result is a nearly doubling of the tax rate on affected individuals. Instead of paying 23.8% they would now be paying 43.4% (39.6% individual rate and 3.8% investment tax rate). This could have a significant impact on investment and the stock market.

Elimination of the step up in basis for Estates over $1 million

From what I’ve read, the first $1,000,000 of an Estate would be exempt from this provision. I’m not sure how that would work, whether taxpayers would have to identify the $1 million of assets that get the step up or whether there will be a methodology baked into the law.

Step up in basis upon death has been a provision that not only helps taxpayers reduce total tax it also cures some basis issues. Let’s say we have a taxpayer that passes away with stock with a Fair market value (FMV) of $2,000,000 and a basis of $1,200,000. Without the step up in basis the heirs of the Estate would recognize an $800,000 gain upon the sale of these securities. With the step up in basis, the heirs are able to “step up” the basis of these securities to the FMV of $2 million. When the securities are sold (assuming a sales price of $2 million), no gain or loss is recognized.

Step up is also helpful if a taxpayer passes and their basis in the assets is unknown. Instead of having to figure out when the securities were purchased and what the purchase price was, all that is needed is the FMV at the date of death, in most cases.

Keep in mind that when the elimination of the step up in basis is combined with the elimination of the long term capital gains rates for taxpayers earning over $1 million, this could become a very painful outcome.

Is there anything we can do about it?

There are a couple of possible of things that may mitigate these provisions.

First of all, the Senate is 50/50 with the VP being the deciding vote and there is also a slim majority for the democrats in the House. This may make both sides negotiate a bit and the resulting compromise may reduce the tax burden being proposed.

Second, taxpayers should examine their portfolio and decide if there is anything they would like to sell in 2021. I can’t tell you if tax legislation will pass, or how painful the legislation may be, but I can tell you that your tax rate will not be going down. This may be the year to sell certain assets while you are still eligible for the capital gains tax rate.

Additionally, if you are in your own business, or have any control over your income, you may want to realize more income in 2021, instead of pushing it off to 2022. This typically goes against the strategies most taxpayers utilize, however, if you believe your income tax rate may be going up it makes sense.

Conclusion

A reminder that any discussion of proposed tax law changes is exactly that, discussion for now. I advise keeping on eye on what’s going on, have some strategies ready to go if you need them and then waiting until the legislation passes or at least until we have more concrete evidence of a legislative change.

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Hang in there and stay safe,

Jeff Skolnick, CPA, M.S. Taxation