As it stands today, states are beginning to certify their election results and it appears that the next President of the United States will be Joe Biden come January 2021. Although President Trump is still pursuing legal avenues regarding his claims, many legal scholars indicate that President Trump will run out of legal avenues, the electoral college electors will cast their votes and Joe Biden will become the next President of the United States.
During Joe Biden’s campaign he unveiled a tax plan which will have significant effects on businesses, real estate investors and high-income earners (those earning above $400,000.00 per year).
However, the most overlooked aspect of the Biden Tax Plan is a major change to estate planning. This change could affect a large number of families who have previously updated their estate plans in light of the Tax Cuts and Jobs Act passed during the Trump Administration.
Please note that this plan has not been passed into law nor has it been introduced into the House of Representatives. Prior to a new tax law (or any law) passing, a Bill will need to be introduced into the House of Representatives and pass both Houses of Congress prior to becoming law.
Currently, there is a run-off election in Georgia in the Senate for the final two seats which will determine which party (Republicans or Democrats) will control the Senate. Therefore, whether this massive change to Estate Planning becomes law will be dependent upon the control of the House and Senate. Even without a Democratic-controlled House and Senate, it is still possible that Biden’s Tax Plan (and the massive change in Estate Planning Strategies) could still take effect. However, with a Democratic-controlled House and Senate, the likelihood of major changes as outlined in Biden’s Tax Plan are even more likely to occur.
What is Changing?
Under the Tax Cuts and Jobs Act passed during the Trump Administration, the tax law exempts the first $11.58 million (or $23.16 million for married couples) of assets transferred at death from the estate tax. Assets over and above $11.58 million are taxed at the top tax rate of 40%.
The Biden Tax Plan proposes to reduce this exemption to $3.5 million for individuals (or $7 million for married couples with a top tax rate of 45%).
The Estate Tax, commonly referred to as the Death Tax, levies a tax upon a person’s total gross taxable estate at the moment of death. A person’s total gross taxable estate includes all of their property including real estate, bank accounts, retirement accounts, vehicles, tangible personal property and even life insurance death benefits.
The Estate Tax is levied and must be paid to the IRS within nine months of the date of death. Further, the Biden Tax Plan is proposing that this tax be made retroactive back to January 1, 2021. The consequence of this tax law change under the Biden Tax Plan is that many more families are going to find themselves exposed to estate tax planning as part of their estate planning strategy than previously during the last 10 years.
A Second Major Change?
An additional major change under the Biden Tax Plan is a removal of the Step-Up Tax Basis. This is a tax concept in which the cost basis of an asset, which appreciates in value, must be valued for determining one’s capital gains tax liability upon the sale of that asset.
For example, let’s say that you buy 100 shares in ABC Company for $100 in 1980 and in 2020 those 100 shares are now worth $10,000. Under current tax law you would owe capital gains tax on the $9,900 gain upon selling those 100 shares in ABC Company. The capital gains tax, depending upon your income could be 0%, 15%, 20% or under the Biden Tax Plan could be 39.6% if your gross income from all sources is over $1 million per year.
However, when you transfer an asset that appreciates in value to another person at death, that asset receives a Stepped-Up Basis. This means that the value of that asset to the person who inherited the asset is the value of that asset on the date of death. Using the example above, instead of selling 100 shares in ABC Company, let’s say you transfer those shares to your son at death. When you die, if the 100 shares are now worth $10,000, then your son’s tax basis is $10,000 and not $100. If your son sells the 100 shares in ABC Company after your death for $10,000, there will be no capital gains tax due as there is no gain due to the Stepped-Up basis.
Under the Biden Tax Plan, the plan is proposing to remove this tax savings provided to families for assets which transfer at death. Under the Biden Tax Plan, there will be no Stepped-Up Basis. Using the example above, the tax basis for your son in ABC Company will be $100 requiring capital gains to be paid on the $9,900 gain.
Both Changes Will Cause Many Families to Change Their Estate Planning Strategies
These two major changes can cause significant problems for families who are not prepared with adequate estate planning. Let’s look at the example below of John and Jane Doe.
John and Jane Doe thought they had a simple estate. John and Jane executed their Wills leaving everything to each other, and then to their three children in equal shares, James, Bill and Mary. John and Jane visited with an attorney several years ago and relied on his advice that this was all they needed.
As is usually the case, John died first leaving everything to Jane. After Jane died, her entire estate was left to their three children. In total, Jane had an estate valued at $5 million (including her home, retirement accounts, investment accounts, life insurance death benefit, stocks, vehicle and tangible personal property).
Unfortunately, the tax laws changed in 2021 and Jane had a $5 million estate, of which $1.5 million would be subject to the estate tax. James, Bill and Mary are now responsible for making sure that the estate pays a 45% tax on $1.5 million of the assets transferred after Jane died. The estate will now owe approximately $675,000 in taxes to the IRS, which will be due within nine months.
The problem for the children is that there is not $675,000 in liquid assets to pay the IRS. Therefore, the children must begin selling property. First, the children sell the family home for $350,000.00. However, John and Jane originally bought the house for $115,000 many decades ago. Therefore, because the tax laws changed and there is no longer a step up in tax basis at death, the children also owe capital gains tax on the $235,000 gain from the sale of the house. Therefore, the children end up paying the IRS $35,200 (assuming a 15% tax rate) on the sale of the home.
This leaves the children with $199,800 in net proceeds from the sale of the home to pay to the IRS on the $675,000 estate tax bill.
The next place the children look is at 200 shares of stock in ABC Company. These shares are valued at $500,000. The children decide to sell these shares to pay the IRS before the nine-month tax deadline. However, John purchased the shares originally in 1980 for $20,000. Due to the tax law changing and the Stepped-Up Tax Basis being removed, there is now a taxable gain on the $480,000 gain. Therefore, there is a capital gains tax on the $480,000 gain. Assuming a 15% rate, the estate pays capital gains tax to the IRS on the sale of the stock in the approximate amount of $72,000.
This leaves the children with a net amount from the sale of $408,000. The children now have liquid assets of $607,800. The children are still short of paying the $675,000 estate tax bill.
As a final matter, the children who inherited a $1 million IRA from their mother decide to remove $100,000 from the IRA they each inherited to pay for the remaining amount of the estate tax bill. However, when you inherit an IRA and treat the IRA as an inherited IRA, your withdrawals are treated as ordinary income. Let’s assume the kids are in a 32% tax bracket. Therefore, the children must pay the IRS $32,000 in taxes from their withdrawal of the inherited IRA.
This leaves the kids with liquid assets of $675,800 to pay the $675,000 tax bill.
How Much in Taxes Did the Estate Pay?
Let’s look at the amount of taxes, expenses and costs paid from the estate.
Estate Value $5,000,000
Estate Taxes $675,000
Capital Gains Taxes $107,200
Income Tax on IRA Withdrawal $32,000
Attorney Fees and Costs $107,500
Net Estate to Children $4,078,300
As you can see, the children paid $921,700 in taxes, costs and expenses to settle their mother’s estate. The children paid $675,000 in estate taxes, $107,200 in capital gains taxes and $32,000 in ordinary income taxes on the IRA withdrawals.
I am certain that John and Jane never even thought of the mess in which they were leaving behind for their children. They never thought that nearly $1 million would be used to pay taxes, attorneys and other costs as part of the settlement of their estate.
Unfortunately, sometimes the law changes. Although this is not current law as of this writing, it is part of the Biden Tax Plan which could become law in 2021 with retroactive effective back to January 1, 2021.
Therefore, the time to update your estate planning strategies and meet with your estate planning attorney is now. You need to prepare for these upcoming changes in advance of the tax plan becoming law.
For More Information
Please contact the Estate Planning Attorneys at Aronoff, Rosen & Hunt at (513) 241-0400. You can also use our contact form to schedule a time to discuss the upcoming tax law changes and how you can structure your estate plan so that you avoid the problems that John and Jane left behind with their estate. Our Ohio Estate Planning Attorneys look forward to speaking with you!