The November 3 election may have dramatic impacts on the income and estate tax laws. These changes could become effective as early as January 1, 2021. Of course, a big uncertainty is the outcome of the election, and whether Democrats or Republicans will control the White House, the Senate and the House. We’ll leave speculation on that issue to others - remembering that whatever the situation now, there is always the possibility of additional “October surprises.”
As the Democrats are the party out of power, tax policy may change dramatically if they “run the table” and take control of the White House and the Senate, in addition to their control of the House. Former Vice President Joe Biden has released a tax plan that would significantly increase taxes on high-net-worth individuals. Click here for a quick look at Biden’s proposals.
For individuals and businesses considering tax planning, a key issue is the effective date of any tax increase or change to the deduction scheme. In situations where taxpayers have control over the timing of income and deductions, taxpayers may be able to effectively “choose” their income tax rates – the rates currently effective in 2020, 2021, or beyond. But making this “choice” would mean accelerating income and paying income tax earlier than would otherwise be necessary (this means giving up the advantage of income tax deferral, which is the best way to decrease a taxpayer’s effective tax rate). Moreover, it may mean making difficult decisions earlier than would otherwise be the case from a business standpoint. For instance, for tax purposes, it may make sense to sell a closely held company before the end of the 2020 calendar year, but there are major logistical and business hurdles to doing so, especially considering the possibility that business and the economy in general recovering in 2021 could net a higher sale price.
Based on the election results, a taxpayer will know who at least some of the tax reform players will be. But if the Democrats make a clean sweep, a taxpayer making a decision about accelerating income at the end of 2020 should weigh not just what parts of the Democratic plan will be adopted, but also how quickly any provisions will be adopted. The advantage of waiting provides not only another year of income tax deferral, but also the advantage of being able to determine the business outlook and possibly some significant insight as to what proposals will be adopted, as opposed to campaign rhetoric.
The newly elected president will take office 20 days after the beginning of the new year on January 20, 2021 and the new Congress convenes on January 3, 2021. If a new president is elected, the Congress is likely to wait until he takes office before passing new legislation. Moreover, it takes time for Congress to get organized and pass bills. But Congress can and has enacted tax legislation that was effective retroactively (at least for a limited period), and such enactments can withstand challenge on constitutional grounds. Pension Benefit Guaranty Corporation v. R. A. Gray & Co., 467 U. S. 717 (1984); United States v. Carlton, 512 U.S. 26 (1994).
Historically, many tax provisions have been effective as of the date the provision was introduced into committee, under the thinking that the introduction of a bill put taxpayers on notice of a change, but limited taxpayers’ ability to tax plan around the change.
Instead, whether Congress enacts particular tax legislation retroactively to January 1, 2021 (or some date during 2021), is somewhat more practical – whether Congress and the President can sign a tax bill early enough so that the policy changes can be incorporated into IRS forms and software before large numbers of taxpayers begin filing their 2021 tax returns. An example occurred in 2018, when, after passing the Tax Cuts and Jobs Act in 2017, the GOP went back and unexpectedly passed an extender bill in early 2018, which extended certain tax provisions effective back to January 1, 2017. These extenders required some taxpayers to file amended and restated tax returns, although the extenders only impacted a limited number of taxpayers.
Another possible limitation on passing tax legislation retroactive to January 1, 2021 (or some other date during 2021), is the reconciliation rule. As a general matter, Senate rules dictate that 60 votes are needed in order to pass legislation that is being filibustered, and Democrats will almost certainly not control 60 Senate seats. In 2018, to avoid this requirement in passing the bill that became the Tax Cuts and Jobs Act, Republicans used a process known as “reconciliation,” which avoids the 60-vote requirement. However, reconciliation can only be used three times during a fiscal year – and, in practice, is usually used only once. The scarcity of reconciliation is a limiting factor regarding passing tax reform as the Senate Democrats have other priorities.
It’s not clear that the Democrats would be limited by reconciliation. In part as a response to the Republican plan to replace the late Supreme Court Justice Ruth Bader Ginsburg, Democrats are seriously considering eliminating the filibuster on legislation, although some moderate Democratic senators have not yet announced their support. Eliminating the filibuster would allow Democrats to avoid the reconciliation process for major legislation, as they could pass all legislation using their simple majority. Eliminating the legislative filibuster rule only requires 50 votes, with the vice president breaking the tie. There may be a few traditionalist Democratic senators who would support preserving the rights of the Senate minority and would vote against eliminating the filibuster.
High on the Democrats’ priority list of legislation would be to repeal the provisions of the Tax Cuts and Jobs Act, which lowered taxes on high-income individuals and businesses. This is a priority shared by most Democrats. But members of the Democratic caucus are not in agreement on proposed tax policy agenda items that go much further than the repeal of the Tax Cuts and Jobs Act, such as taxing capital gains and dividends at the same rate as ordinary income for taxpayers with more than $1 million in income. Although the Democrats could win a Senate majority, if they do, it will be because relatively moderate Democrats carried red-tinted states, such as North Carolina. Such large tax increases may not be popular with these senators, whose votes may be crucial for passage. In addition, some senators who otherwise generally support tax increases will want to wait to enact them until the economy has recovered.
The disagreements within the Democratic caucus may require more debate and negotiation on a large plan to both repeal the TCJA provisions and to implement some or all of the ambitious tax policy proposals in the Biden platform. In addition, while there is significant support among Democrats for tax reform, the new Congress will have significant challenges in responding to COVID-19, including addressing a significant stimulus effort.
It is possible that Democrats, after eliminating the filibuster, quickly coalesce around a proposal to repeal the TCJA provisions and provide for some limited increase in personal income and capital gains rates effective retroactively in 2021 and then leave larger reforms for another tax bill to become effective in 2022.
Least likely of the possible policy outcomes, would be the passage of a large tax reform proposal that implements large tax increases on wealthy individuals and businesses, and is passed and signed in time to create the tax returns and instructions that taxpayers could use to file their tax returns under the new rates in 2022. Given the logistical hurdles of both getting agreement within the House and Senate Democratic caucuses and also the practical requirements of implementation, this seems unlikely.
Whether effective in 2021, 2022, or later, if Democrats take the House, the Senate, and the presidency, there will almost certainly be tax reform and income taxes will increase on high-net-worth individuals and businesses. Our observers see the ultimate outcome as somewhere in the middle between a repeal of the TJCA and the Biden proposals: the effective long-term capital gains rate increases (perhaps just a redefinition of “long term” and probably some rate changes as well, not entirely eliminating the preferred rate on capital gains and dividends), and at least some deductions are limited (perhaps with the reinstatement of the Pease limitation or some sort of negative adjustment and loss of the QBI deduction). The state and local tax deduction will be reinstated and the charitable deduction will be protected and perhaps even expanded. The overall result would be a tax reform that is far from the “significant” progressivity promised in the current Biden proposal, but a rate increase nonetheless.
For estate taxation, beyond the repeal of the TCJA, which could happen quickly and include the loss of the doubled gift and estate tax exemption, observers do not see much in the way of additional reform. Increasing the estate tax may be popular among a certain branch of the Democratic Caucus, but there is a realization that the relatively small amount of revenue is not worth the internal fight, as compared to other revenue raisers. The estate tax increases will raise unpopular issues (family farms, the definition of “small” business, vacation homes) to make estate tax changes not worth the amount of debate. Although this may be the case, clients should very much consider estate tax planning before the end of the year.
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