Coming Soon! Higher Income and Capital Gains Taxes & More – Beware Trusts, Expatriation Planning

The House Ways and Means Committee recently released its proposal (HWM Proposal) to fund the US$3.5 trillion “Build Back Better Act” reconciliation spending package.  Not unexpectedly, the proposal takes aim at high income earners. Here’s a few pointers that are important for many of my readers, especially those with US trusts or those looking at expatriating.

Increases for Income Tax Rates / Rate Bracket Adjustments

The HWM Proposal contains an increase in income tax rates, hoisting the top individual tax rates up to 39.6% for ordinary income. It will apply to: married persons filing jointly when they have taxable income over US$450,000; married persons filing separately with taxable income over US$225,000; head of household filers with taxable income over US$425,000, and to single filers with taxable income over US$400,000. The rate increase will be felt most harshly by any US trusts and estates since the 39.6% rate will apply when taxable income is over US$12,500. These amounts will be adjusted for inflation in future tax years.

The tax rate brackets will also be adjusted. As a result, taxpayers on the upper end of the 32% and 35% rate brackets may see some unexpected tax increase as a result.

More, More, More –

Expanded Net Investment Income Tax

My readers are likely well aware of the Net Investment Income Tax (NIIT).  Broadly speaking, the NIIT is a 3.8% surtax on “net investment income” that applies to certain high-income individuals.  Net investment income includes interest, dividends, capital gains, annuities, royalties and passive rents as well as income from businesses, such as trading of financial instruments and commodities and businesses that are considered “passive” with respect to the taxpayer.

Not all taxpayers are subject to the NIIT. Two basic requirements must be met for the NIIT to apply. The taxpayer must have both “net investment income” and modified adjusted gross income (“MAGI”) that exceeds certain dollar thresholds. The thresholds, which are not indexed for inflation, depend on the taxpayer’s filing status.  Individuals having (i) MAGI that is over the applicable threshold amount, and (ii) net investment income, must pay 3.8% of the smaller of (i) or (ii) as their NIIT.

You can learn more about the NIIT, the MAGI thresholds and how the Biden Administration’s so-called Greenbook planned to expand the NIIT at my blog post here.

Under the HWM Proposal, the NIIT will be expanded much as set out earlier in the Greenbook.  The NIIT will not only cover passive investment income. Under the proposal it will include any income derived in the ordinary course of business for single filers having over US$400,000 in taxable income (US$500,000 for joint filers).

As for trusts and estates, the expanded NIIT will have a harsh impact.  The NIIT will apply to trusts and estates if they have US$13,050 of adjusted gross income in 2021 and that threshold will only be slightly higher each year thereafter. This threshold is very low when compared to the income thresholds for individuals under the NIIT rules. This means that trusts and estates with any ownership interests in a businesses will likely be subject to the 3.8% tax.

It is important to note that estates and trusts are subject to the NIIT only if they have undistributed net investment income.  If the income received by the trust/estate is paid out to its beneficiaries, then the beneficiaries themselves will be subject to the tax, not the trust or estate.  Given the huge differences in the income thresholds for individuals versus trusts/estates, the ability for the trustee to distribute to beneficiaries will be critical.  This is an important planning point and trustees must be aware of these possible changes and plan accordingly.  More on this point below.

A New 3% Surcharge! Trusts/Estates Beware

The HWM Proposal contains a brand new surcharge of 3% that will apply to high income earners. It’s in addition to the 3.8% NIIT. Here is the scoop – the additional 3% tax will be imposed on individual taxpayers to the extent that they have “adjusted gross income” (“AGI”) in excess of US$5,000,000 (US$2,500,000 if married filing separately).

While many of us are not earning such amounts – there’s a nasty rub for trusts or estates. This 3% tax will apply to a trust or estate having income in excess of only US$100,000!  Obviously this new surcharge will be a very big issue for trusts, but a savvy trustee can plan and reduce the hit by making distributions to beneficiaries of so-called Distributable Net Income (DNI). Under the tax rules, DNI distributions will reduce the trust’s taxable income. The 3% surcharge under the HWM Proposal will only apply to income in excess of the US$100,000 that remains in the trust after taking into account distributions made to the beneficiaries. As such, the trust’s taxable income can be brought down to the US$100,000 (or less) threshold and prevent imposition of the 3% surcharge. Similar planning can be used for the NIIT.

Trustees and their counsel must carefully examine the trust documents and applicable law to make sure capital gains will not be treated as “principal” (and thus not distributable to the beneficiaries).  Most states permit trust documents to specify that a fiduciary has the power to treat capital gains as income that can be distributed to beneficiaries. This is a “reallocation” power.  However, there are many nuances that come into play with a reallocation power, especially in family trusts.  It is common for the trust deed to state that the reallocation power cannot be exercised if the trustee is a beneficiary of the trust.  Thus, deeds should make clear that the power may be exercised by a trustee even if the trustee is also a beneficiary of the trust.

Under the HWM Proposal, these increases will generally apply to taxable years beginning after December 31, 2021. This means there is still time to do some planning.  Earn as much as possible now while the tax rates have not increased and get those trust deeds in order to try and avoid the impact of the new surcharge (and the 3.8% NIIT).

An Increase in Capital Gain Rate

Capital gains that are long-term gains and so-called “qualified dividends” are taxed currently at a maximum rate of 20%. Under the HWM Proposal this rate will increase to 25% for both kinds of income.  The higher rate will be effective for qualified dividends paid, or sales that occur on or after September 13, 2021 when the proposal was released.   The current maximum 20% rate will continue to apply to gains earned prior to September 13, 2021, as well as any gains that originate from transactions entered into under binding written contracts prior to September 13, 2021.

For an individual who is expatriating and treated as a “covered expatriate”, he or she will be subject to the exit tax on deemed sales of worldwide assets. These “pretend” sales will typically result in long-term capital gain.  The maximum rate of tax (20% or 25%) on that long-term gain, will be determined by the expatriation date if this proposal becomes law. The increase in capital gains tax is another big reason to avoid “covered expatriate” status!

Going SouthGift and Estate Tax Exemption Amounts

The HWM Proposal would reduce the gift and estate tax exemption from US$10 million per person (as indexed for inflation) to US$5million per person (as indexed for inflation).  While this reduction is already scheduled to take place on January 1, 2026, the HWM Proposal would have the reduction occur  as of January 1, 2022.  The exemption amount is estimated to be approximately $5.85 million per person, as indexed for inflation.  Under the proposal, the reduction will not be retroactive, so taxpayers still have a very narrow window of opportunity to use the increased exemption amounts before the end of this year without fear of a “clawback”.

Gifting appreciated assets is a very useful planning tool for those considering expatriation and reducing net worth below US$2 million, to avoid “covered expatriate” status.  My blog post here discusses this expatriation planning opportunity.  Those looking at expatriation who need to reduce net worth, should be working fast to beat the clock. We are here to help and have the experience you need.

Posted September 30, 2021

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