Andy Friedman: Biden Tax Plan Will Get a “Major Haircut”

The legislative packages

The Senate and House are considering two major pieces of legislation, The American Jobs Plan and the American Families Plan. The Jobs Plan provides $2.3 trillion funding of infrastructure and is funded by increases in the corporate income tax. Friedman said it has bipartisan support and expects it to pass in October. The plan will be pared back, he said, but it will inject at least $1.2 trillion into the economy over the next five years.

The American Families Plan, which is sized at $3.5 trillion, will be the largest expansion of spending since the New Deal, he said. It will finance social programs such as universal pre-kindergarten, extended childcare, and expansion of the coverage provided under the ACA (Obamacare). it contains the tax increases targeted at individuals. It must go to House floor, the Senate finance committee and through reconciliation before it is passed, where changes will be made.

“But there will be a tax bill moving through Congress,” Friedman said.

We will not see $3.5 trillion, Friedman said. He expects the final size to be $1.2 to $1.5 trillion.

President Biden will not allow tax increases on those making less than $400,000 and that principle has guided the legislation. Virtually all provisions of the plan will be effective January 1, 2022, and not retroactive, he said. But there are exceptions, which I discuss below.

The Families Plan will increase the marginal ordinary income tax rate from 37% to 39.6%, restoring the pre-Trump rates. There will also be a 3% excise tax on income in excess of $5 million. This will be in the final legislation, Friedman said.

The marginal capital gains tax rate will increase from 20% to 25% (although Biden had wanted it equal to the income rate of 39.6%). That 25% rate is necessary to satisfy Manchin, he said. It will be retroactive to September 13, 2021, and any transaction after that will be subject to the higher rate.

“That may stick,” Friedman said. “But I think there is a decent chance that [September 13] date will slip, because it will take a long time to pass the legislation, making it hard to keep that date.” The higher rate would apply only to those with income over $400,000, Friedman said.

There is a window to take action, he said, for those contemplating transactions that would be subject to the capital gains taxes.

Section 199A allows small business owners, through subchapter S, to claim 20% of business income as a deduction. The legislation phases out the benefit for those with $500,000 of income for joint filers and $400,000 for individual filers. That is likely to pass, he said, although with potentially higher deductions.

There is a provision to apply the Medicare 3.8% surcharge to subchapter S income unless that income is subject to the proposed 3% excise tax. One or the other will apply, he said.

The favorable treatment of carried interest will pared back. It will require a service partner to hold the asset for five years before selling to get capital gains treatment.

The House plan also addresses retirement plans. Roth conversions will be eliminated for taxpayers with income of $450,000 for joint filers and $400,000 for single filers, effective December 31, 2031. That date, he said, “may be a typo or a generous allowance” to give taxpayers a 10-year runway. He is not sure. But he called it a “draconian, widespread provision.” Back door IRAs are where an individual above the income limits makes a non-deductible contribution to an IRA and rolls it over to a Roth. This has been a great concern to the IRS, he said, and the legislation will ban them regardless of income level. This means that conversions can be done only with pre-tax money. The IRS considers backdoor Roth conversions “a tax-avoidance scheme,” Friedman said.

The legislation also goes after very large IRAs, which he said are used by venture capital and private equity investors. It will prohibit any contributions if the total value of the IRA exceeds $10 million. It also requires distributions for IRAs and 401(k) plans that have more than $10 million in assets; half of the amount over $10 million must be distributed and presumably taxed. If the account is over $20 million, then everything over it must come out immediately.

Only securities registered with the SEC can be held in an IRA, and that will be effective January 1, 2022, with a two-year transition. That will prevent private equity, venture capital and other illiquid investments from being held in IRAs.

Those provisions related to IRAs are all quite likely to pass, Friedman said. “There has been too much messing around with Roth conversions and IRAs,” he said, “and it is necessary to stop them.”

There will not be a repeal of stepped-up basis at death, but there is a reduction from $11.7 to $5 million in estate tax exemptions, effective January 1, 2022. The legislation will also eliminate some sophisticated wealth-transfer techniques, such as grantor trusts and minority discounts on publicly traded securities.

The corporate tax rate is set to increase from 21% to 26.5% under the Jobs Plan, but Manchin will require it to come down to 25%, Freidman said. There is a provision to tax U.S. companies on foreign income. This is a big deal, he said, because companies avoid taxes by moving operations and earnings offshore. This provision sets a minimum of 16.5% tax on offshore earnings. This is a major deal for companies, Friedman said, and “it is up in the air”

There will be no repeal of 1031 exchanges or an elimination of tax preferences for fossil fuels. But there are provisions that may still go into the legislation, such as increasing the limit on SALT deductions, which is $10,000. This affects high-tax-rate states, such NJ, NY and CA. “We will see something,” he said, “perhaps a phasing in. I would be surprised if it is eliminated entirely.”

Dealing with the proposed plan

Despite the provisions that are uncertain, Friedman offered some advice for reducing taxes in anticipation of the legislation passing.

The markets will like the stimulus from the Families Plan, he said, even if it is pared back to $1.5 trillion. But markets don’t like tax increases. The proposed deal will mollify the impact. There will be volatility from all elements of the plans, he warned.

“Overall,” he said, “it will be good for the market.”

Advisors should consider accelerating income and deferring deductions and use Roth conversions to take advantage of lower rates. Accelerate charitable contributions to get above the standard deduction, he said, perhaps using a donor-advised fund.

After the higher tax rates take effect, it will favor annuities.

For capital gains, consider selling appreciated assets if there is a chance the effective date is repealed. Wash-sale rule only applies to losses, so investors can sell an asset at a gain and buy it back. Defer capital losses, he said, and consider installment sales of appreciated assets.

For retirement plans, do a backdoor Roth now if you like them, he said. Keep accounts below $10 million. Use the charitable provision, which allows $100,000 of gifting, to reduce the size of an IRA.

Gift now, he said, using the $11.7 million estate tax exemption. “Now is the time to make gifts,” he said. Look at life insurance as a way around the higher estate tax.

Robert Huebscher is the CEO and publisher of Advisor Perspectives.

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