With the end of the year quickly approaching, individuals should consider making proactive moves to minimize their tax liability. Tax planning has been made more complicated in 2021 by the fact that a bill is currently working its way through Congress that could result in significant changes to the tax law. The Build Back Better Act (“BBBA”), which would increase taxes on high-net worth individuals and corporations, was passed by the House on November 19, 2021, but has not yet been passed by the Senate. This article presents a range of tax strategies based on the proposed provisions of the BBBA; however, taxpayers should be aware that the bill may not pass, and if it does pass, some provisions may be modified or even removed from the final version passed into law.
- Review Timing of Income and Deductions
In general, postponing income to a subsequent tax year and accelerating deductions into the current year is advisable to take advantage of the time value of money. Contrary to traditional planning, individuals with an annual income over $10 million may need to consider accelerating income and deferring deductions due to one of the provisions within the BBBA. The bill proposes to add a 5% surtax to households with adjusted gross income (“AGI”) that exceeds $10 million, with an additional 3% tax (for a combined 8% tax) on households with AGI that exceeds $25 million. For this reason, individuals with income in excess of these amounts should evaluate whether any income expected to be earned in 2022 can be moved into 2021 instead to avoid the higher tax rates, and whether any deductions that would normally be paid before the end of the year can be postponed until 2022.
The BBBA also contains a provision that would cause active business income from S corporations, LLCs and other flow-through entities to be subject to the 3.8% net investment income tax for individuals earning over $400,000 ($500,000 if married). In the past, individuals were not required to pay this tax on flow-through income if they were active participants in the business. If this provision becomes law, then active business owners with income over the threshold amounts should also consider accelerating business income into 2021 and postponing business deductions until 2022.
Note: For taxpayers who would not be affected by the proposed surtax on individuals with income over $10 million or the imposition of the net investment income tax on active business income, the more traditional planning techniques of deferring income and accelerating deductions are still appropriate.
- Utilize Remaining Gift and Estate Tax Exemption
The combined estate and gift lifetime exemption is at an all-time high in 2021, allowing for up to $11.7 million of wealth per individual ($23.4 million for married couples) to be passed on to heirs during lifetime or at death without incurring transfer taxes, including the estate tax or “death tax”. This amount is scheduled to be cut in half as of January 1, 2026, and while previous versions of the BBBA would have moved the effective date of this reduction up four years to January 1, 2022, the current House bill does not include this provision. There remains a possibility that this provision, as well as other proposals limiting the use of grantor trusts and valuation discounts, could be re-introduced into the BBBA or subsequent legislation. As a result, individuals with significant assets should work with their estate planners to ensure that they maximize the use of the lifetime exemption amount while it is still available, whether through direct gifts or transfers in trust.
- Complete a “Back-door” Roth IRA Conversion
One of the tax planning strategies that could be put to an end by the BBBA is the so-called “back-door” Roth IRA conversion, which involves converting after-tax contributions (for example, from a non-deductible IRA) into a Roth IRA. This technique can circumvent the contribution limitations that prevent high-income taxpayers from contributing directly to Roth IRAs. The bill proposes to prohibit such conversions effective January 1, 2022, meaning that 2021 might be the last chance for individuals to implement this strategy. Individuals with after-tax contributions in their traditional IRAs should consider completing a Roth IRA conversion before year-end, with the caveat that this could result in taxable income being recognized if there are also pre-tax savings in the traditional IRA.
- Harvest Tax Losses – Including Cryptocurrency
Individuals who recognized capital gains in 2021 can offset this income by selling stocks, securities and other capital assets with unrealized losses. In addition, up to $3,000 of capital losses can be utilized to offset other types of income, including wages or business income. Investors who own cryptocurrency should also consider selling any holdings that could generate a tax loss, due to a change proposed by the BBBA to the “wash sale” rule. This rule prevents individuals from recognizing a tax loss on the sale of a stock or other security if the same stock or security is bought back within thirty days. While cryptocurrency assets are not currently subject to the wash sale rule, the most recent version of the BBBA would cause cryptocurrency to be treated as a security subject to this loss disallowance. Individuals wishing to take advantage of this loophole should consider harvesting tax losses on cryptocurrency in 2021 while retaining the flexibility to buy back the same asset before the end of the year.
- Monitor Other Provisions
Like the potential reduction to the estate and gift tax exemption, not all provisions that were originally in the BBBA were included in the House version of the bill. As the bill continues to be modified, some of the excluded provisions applicable to individuals could potentially be re-introduced. This includes a cap on the amount of the allowable qualified business income deduction, an increase to the top individual income tax rate and capital gains tax rate, significant limitations on the use of like-kind exchanges, and changes to the carried interest rules. Any subsequent changes to the bill should be monitored with respect to these and any new provisions that may have an impact on year-end tax planning.
Effective tax planning should not focus solely on the immediate tax savings but should also include a consideration of tax liabilities in future years as well as any non-tax considerations. Transactions should be entered into carefully due to the uncertainty surrounding the passage of the Build Back Better Act and which provisions will ultimately be included. By working with a professional tax advisor, individuals can ensure that they are apprised of the latest developments in the BBBA and implement tax strategies accordingly.