Ultra-rich have a tax problem: Not knowing when to sell

Joan Crain’s job is to guide the wealthy through complicated financial decisions where mistakes can cost millions of dollars. That task is proving particularly tricky now thanks to Joe Biden’s proposed tax plan and the lack of clarity over what the Democrats will pass.

“We have to calm them down,” said Crain, global wealth strategist at BNY Mellon Wealth Management. “We don’t know what’s going to happen.”

Rich Americans and their advisers have known taxes could be going up at least since January, when Democrats won two Senate elections in Georgia that gave them effective control of both chambers of Congress.

Now the lawmakers are pushing to raise taxes on Americans earning more than $400,000, with proposals that hike rates on corporations and capital gains. They’re also seeking to increase funding for the Internal Revenue Service and close a variety of loopholes that millionaires and billionaires have come to rely on.

What’s still up in the air though — and will remain uncertain either until President Biden signs a bill into law, or the whole effort collapses in Congress — is almost everything about the tax package, including which rates Democrats ultimately set and even when its various provisions go into effect. That’s making it particularly challenging for wealth advisers to figure out exactly how Democrats might force the rich to pay more.

“We have to look at every client to see where they’re going to be vulnerable tax-wise going forward,” said Crain.

CAPITAL GAINS TAX

In April, Biden and the White House laid out one plan, which alarmed the super wealthy with a proposal to almost double their tax rate on long-term capital gains — to the level that wage income pays — while requiring taxes on those gains be paid before assets are inherited.

Then, a House plan approved by the Ways and Means Committee this month scrapped that idea, merely proposing to raise the top capital gains rate to 25%, from 20%. But, after breathing a sigh of relief, advisers to the wealthy soon realized the bill contained language that would kill off some of the most popular ways the richest 0.1% legally circumvents taxes.

The proposal would block trusts and other techniques used to get around the estate and gift tax, which is a 40% levy on the transfer of large fortunes from generation to generation. It also would shrink a lucrative tax break primarily enjoyed by Silicon Valley, and tighten rules on wealthy Americans’ individual retirement accounts, or IRAs.

Democrats are divided on how quickly they want to move this bill through Congress. Some progressive lawmakers are advocating for a vote in the House as soon as this week. Moderate Democrats, including Senator Joe Manchin of West Virginia, have said the negotiations should not be rushed and could extend into 2022. Many congressional experts expect the bill will pass just shortly before the Christmas holiday, a date that has historically served as a motivating deadline for lawmakers to reach a deal so that they can go home to celebrate with their families.

For advisers executing sophisticated tax-avoidance strategies, the details matter. So does exactly when changes get implemented. The White House’s plan said it would hike capital gains rates starting after the date it was announced — in late April — a retroactive increase that would have meant rich investors owe almost twice as much on transactions executed in May than in March.

Then the House proposal moved its more modest capital gains hike to start after Sept. 13. Other tax provisions in the bill had different effective dates, including the day they become law and the end of the year. There’s no guarantee any of those dates will remain in final legislation.

Clarity on the timing of tax hikes would make them easier to avoid. If investors know taxes are going up in the future, they can rush to sell now.

“It seems like they’re trying to create paralysis, so people don’t do anything,” said Jeremiah Barlow, head of family wealth services at Mercer Advisors. He thinks there’s a 50-50 chance that the effective date on the capital gains hike could slip to later in the year as negotiations over the package stretch onward.

EFFECTIVE DATES

The question of effective dates is especially important for people already in the midst of large transactions that would trigger capital gains. For clients about to sell a business, for example, the best advice may be to hurry up and hope your transaction falls under the lower tax rate, Barlow said. “Either the rate is going to go up, or you’re going to get the windfall of it being lower.”

The threat of higher taxes is pushing some rich Americans to make moves. Owners of multi-billion-dollar businesses have sped up plans to sell them off, advisers say, hoping the deals are completed in time to avoid the tax hikes. Other wealthy investors are exploring niche strategies, including one called private placement life insurance, that are designed to avoid taxes on future gains.

In some cases, haste could be a mistake. Both the White House and House legislation would hike the top ordinary rate back to the pre-2018 level of 39.6%, up from 37%, at the end of the year. The House bill would also add a 3% surcharge on incomes above $5 million next year. If those and other tax hikes take effect in 2022, it might be tempting to try to pay more to the IRS this year in ways that would lower future years’ tax bills.

Strategies for doing that include speeding up business income, deferring charitable contributions and other deductions to future years, or moving money from traditional IRAs to tax-free Roth accounts.

But all these moves could backfire. Taxes might not rise as much as expected — or might not happen at all. The House bill includes a $10 million cap on Roth IRAs, and Democrats have previously discussed limiting the total size of wealthy taxpayers’ deductions.

“I wouldn’t make any big moves in a client account until the final ink is dry,” said Dana D’Auria, co-chief investment officer at Envestnet. “We know the package probably gets cut back. You could have last-minute amendments that change the picture.”

ESTATE AND GIFT TAX

When it comes to planning to avoid the estate and gift tax, however, tax advisers are urging clients not to be complacent. The House legislation would take the lifetime exemption — the amount that can be transferred to heirs tax-free, currently $23.4 million for married couples — and cut it in half. Even more disruptive for wealthy families is that the bill targets most of the ways they can avoid the estate tax entirely, by funneling millions and billions of dollars more to heirs tax-free.

In the House bill, the new rules only apply to trusts “created on or after the date” the bill becomes law. The lifetime exemption would drop after Dec. 31. That gives the wealthy a shrinking opportunity to move as much of their fortune to heirs now as possible. It’s a strategy estate planners have been urging on their clients for the past couple of years, as it looked like Democrats might re-take control of Washington. If Congress does nothing this year, the lifetime exemption is still slated to drop at the end of 2025.

Even if rich people aren’t sure of exactly what to do, advisers say they’re telling clients to set up trusts and get other paperwork ready. If major changes are implemented at the end of the year or even earlier, the country’s estate tax experts simply won’t have time to help every wealthy person react in time.

“We’re going to be horrendously busy from now to the end of the year,” said Richard Levine, special counsel in the private client and tax team at Withers law firm. “This is why I’ve been screaming at all my clients: ‘You should have done this over the summer. I know you didn’t like the idea of paying legal fees in an era of uncertainty. But now we’re all going to be so overwhelmed.’”

[More: Heeding tax winds, advisers chart new financial tactics for clients]