On Tuesday, November 3rd, Americans went to the polls and cast votes for President, Senators, and House members. In some cases, the results are still being tabulated (or subject to challenge). However, the picture becomes a little clearer for individuals and businesses doing end of year tax planning for 2020 and for upcoming years.
For an in-depth discussion of the impact of the election on tax policy, please click here for the video of our November 10th webinar featuring former Congressmen (now directors of public affairs with Foley), Mike Capuano, Dennis Cardoza, and Scott Klug, discussing post-election tax policy and answering live audience questions.
While Vice President Biden and Senator Kamala Harris were elected, they will likely take office with a slimmed down House majority and a minority in the Senate. To date, Republicans have likely won 50 Senate seats; Democrats have 48 Senate seats. It appears both Georgia Senate seats will be subject to a January 5th run-off. While Biden-Harris appears to have won Georgia, Georgia is historically Republican, and observers, including our webinar panelists, believe it is highly likely that Republicans will win at least one seat to allow for a Republican majority in the Senate. In the unlikely event Democrats win the two Senate seats, they would hold a majority, with Vice President Harris holding the tie-breaking vote. In this case, Democrats would be a weak majority (essentially allowing every Democratic Senator a veto). West Virginia Senator Manchin has said that he will not vote to end the filibuster, which means a Democratic-only tax bill must use the reconciliation process (with its limitations). In addition, there will be significant focus on COVID-19 efforts, including economic stimulus.
Due to Democrats probable minority in the Senate, the prospects for major tax reform in the next Congress are slim. Major changes, such as a full repeal of the 2017 Tax Cuts and Jobs Act or Democratic proposals to impose income tax increases on high-net-worth individuals and businesses, are unlikely. It is also unlikely that Congress would reduce the current gift and estate tax exemption (increased by the Tax Cuts and Jobs Act to $11.6 million until 2026) or eliminate the 20% rate for long-term capital gains and long-term dividends for high-net-worth individuals. Moreover, because of the difficulty of getting agreement in a closely-split Congress, it is even less likely that any change would be enacted soon enough to make it retroactive to January 1, 2021.
However, this does not mean that tax policy changes will not occur. Changes to current tax law can still happen through administrative actions and legislative tweaks to current tax law. Joe Biden will appoint a new Treasury Secretary, who can make substantial policy changes through new Treasury Regulations and Administrative Acts. Senator Elizabeth Warren has been floated as Treasury Secretary; although, because of probable Republican control of the Senate, appointment of Senator Warren (or someone with a similarly aggressive approach to policy) may spark an unwanted confirmation battle. However, there are other Treasury appointments that could be filled by Democrats looking to be aggressive with administrative changes that may be unfavorable to high-net-worth taxpayers. New political appointments may cause the IRS to change its approach to issues such as the taxation of carried interest and other areas that rely on administrative regulations, as opposed to a change to the Internal Revenue Code itself. As carried interest rules stem from statutory analysis, case law and IRS guidance, the IRS may have greater latitude to institute change in the absence of congressional legislation. President Biden and Democrats will likely prioritize funding for the IRS in future budgets, which will give the IRS more resources for enforcement, allowing the IRS to audit more tax returns.
Importantly, divided government does not mean that there will not be statutory changes. Congress can agree to make tweaks to the tax code even when there is divided government. The 2019 SECURES Act is a good example. In looking for revenue offsets for certain changes to retirement plans, Congress adopted complex changes to the taxation of inherited IRAs which made an inherited IRA less valuable as a tax vehicle. As large bills move through Congress, it is entirely possible that Congress will identify revenue raisers in order to offset the costs of policy changes elsewhere, and this is even more likely as Democrats do have a significant policy agenda beyond taxes. President Biden and the Democrats are likely to push adding back the state and local tax deduction because of its significant impact on taxpayers in states with high tax rates (which also tend to be Democratic in voting patterns).
When turning to raise revenue, and knowing that large statutory changes are not available, Congress often does not act based on good tax policy principles—Congress acts with an eye toward exigency and less toward overall policy outcomes (such as fairness or simplicity). In this way, smaller “tweaks”—changes that result in increasing revenue but not altering overall rates—are always possible to be taken off the shelf and added to legislation in order to pay for expenditures or other tax changes. Because of the nature of the process, it is difficult to speculate which “tweaks” will be part of any given legislation. Items in the Biden proposals that maybe in play include certain accelerated depreciation provisions, the basis-step up at death, section 1031 exchanges, the re-imposition of Pease Limitations (which disallow a certain level of deduction for high income taxpayers), and adjustments to capital gains rates. Adjustments to calculating deductions (applying deductions as a tax credit equal to the amount of the deduction multiplied by a set rate, such as 28%) may be on the table as well. For instance, it is possible Congress could alter the definition of what qualifies as a long-term versus short-term capital gain. Predicting tax changes in this environment is highly speculative. For individuals and businesses who rely on a narrow and specific favorable code section or a favorable interpretation, a presidential transition creates substantial risk that such code section or interpretation could be lost in a rush to raise revenue for an unrelated purpose.
Lastly, in looking ahead to 2022, because the Democrats lost seats in the House and as the map in 2022 favors the Democrats, with more Republican incumbents in “purple” states up for re-election, President Biden and the Democrats may be in a better position to buck the trend of the President’s party losing seats in the mid-term election. If the Democrats continue to hold the House and if they were to take the Senate in 2022, there is a better possibility of a broader tax reform along the lines of the Biden campaign proposals.