What If We Flipped the Proposed Tax Hike On Its Head?
House Democrats recently shared a preliminary plan for tax hikes and the news doesn’t look good for corporations, high-income business owners or your family’s private wealth. But we advise against reacting with any degree of emotion that might range from mild irritation to raging despair. Everything will be OK.
Here’s what we know for sure: When it comes to wealth creation, taxes will always cause friction. Sometimes, though, it can feel like more than friction. Sometimes it feels like a giant serving of friction with a side of abrasion. Still, there is little cause for concern. And there are many reasons why.
If you’ve established a tax plan that organizes assets according to strategy, that plan will marginalize the whims of partisan policy, like the latest proposed tax hikes. History tells us that tax rates ebb and flow. Those wealthy taxpayers in the highest rate bracket 21 years ago were taxed at 39.6%. The following year, the same rate bracket was at 39.1%, then it dropped to 38.6% in 2002. Fast forward to 2003 and the same group enjoyed a low 35% at the highest rate bracket. By 2013, rates were back up, rising to 39.6%. But 2018 brought lower rates for the highest rate bracket: 37%. And that’s where we’ve remained until now.
There’s also this: The proposed changes to the current tax rates will face some opposition within the Democrat’s own party. In fact, senators Joe Manchin, D-W.V., and Krysten Sinema, D-A.Z., have expressed major pause about the spending package associated with the tax changes, and Manchin even floated the idea of punting the bill until 2022. How much uncertainty about passage or where things will land is unclear, but there will be bumps in the road for certain. No matter what, the current proposal isn’t likely to pass the House and Senate without major modifications.
In terms of next steps, those who authored the new tax proposal hope to reconcile policy differences among House Democrats in the coming weeks. But this is very unlikely given what we’ve heard directly from key Democrats who will be “do or die” votes. Here’s a brief look at the current proposal, as it stands at the time of this writing:
- The corporate tax rate would go up to 26.5% from 21% for businesses that report more than $5 million in income.
- The corporate tax rate goes down to 18% for small businesses that make less than $400,000 and remain at 21% for all other businesses.
- For individuals, estates and trusts who make more than $5 million in adjusted gross income (or $2.5 million for individuals filing married filing separate), the proposal would impose a 3% surtax.
- An increase to the top marginal income tax rate to 39.6% from 37% is proposed for households that report taxable income over $450,000 and for unmarried individuals who report more than $400,000
- The Qualified Business Income Deduction (QBID) would be limited to $500,000 for households filing married filing jointly and to $400,000 for single filers.
- The plan would also increase the top tax rate for capital gains to 25% from 20% for gains recognized on or after September 13, 2021.
- The Net Investment Income Tax (NIIT) would expand to include any trade or business income (i.e., not just passive sources) for households that report taxable income more than $500,000 and for unmarried individuals who report more than $400,000.
- Addicus Note: Wages will not be subject to this newly expanded NIIT, thereby allowing shareholders of corporations to actively plan around the NIIT expansion.
Why all the tax hikes? The New York Times reports changes would be made in order to raise as much as $2.9 trillion to “pay for most of President Biden’s sweeping expansion of the social safety net.” Oh and there’s this: “The proposal would also provide $80 billion over the next 10 years for the Internal Revenue Service (IRS) to beef up tax enforcement.”
The IRS : Traffic Cop or Assassin?
We’ll want to unpack some of the nuances that make a tax plan something other than what many construct during tax season in a mad dash before filing for an extension. But it’s helpful to first take a hard look at the IRS. Because how you perceive this federal agency affects how you approach your taxes. These guys are not supposed to be assassins, but rather traffic cops.
Still, it’s not uncommon for a taxpayer to take conservative, black-and-white positions on tax documents for fear of being audited, yet that same taxpayer will fail to report off-the-books income. But that’s all wrong. Failing to report income leaves no wiggle room. The language is clear: all income from whatever source derived.
Alternatively, taking bold positions can result in substantial tax saving. And if the bold positions are challenged? Well, when it comes to the IRS and how you view the agency, that’s the whole point. You’ll want to create a tax return that saves as much as possible, while creating the least amount of scrutiny. But challenges are OK, because the IRS is the traffic cop of finance. Their purpose is to provide checks and balances. So maybe the IRS disagrees with a position taken on a tax return. Maybe the agency takes issue with a planning mechanism on a substance-over-form, economic substance or business-purpose.
That’s where your tax plan comes in. Sometimes the IRS will be right in its challenges. Other times it challenges a position and later backs off or, sometimes, loses. But if you’ve done your planning throughout the year, and you’ve developed structure and tax-friendly circumstances for your Family Wealth Enterprise, organized assets according to strategy and established good documented facts and circumstances to support bold positions, you can afford to be scrutinized by the IRS. Why? Because your plan has already been scrutinized and implemented by professionals. It’s been vetted.
A Tax Plan Codifies Your Personal Financial Enterprise
The Internal Revenue Code is an extremely complicated and nuanced piece of legislation, and while the IRS works to enforce the laws as written, opportunities can be found if you know where to look. What may appear to be black-and-white to a non-professional, could be an opportunity for substantial tax savings in the hands of an experienced advisor who knows how the IRS interprets and enforces the law.
Here’s a scenario we used in an Addicus whitepaper on tax mitigation. Let’s say you’re a self-employed entrepreneur earning a seven-figure income. With those earnings, you can likely save at least $100,000 in taxes annually. Plus, since it’s a tax saving, you can think of it as after-tax income. Now that $100,000 in savings is equivalent to earning an additional $200,000 each year in taxable income.
Next, let’s assume you invest these savings every year from age 40 until age 65. That means you’d have invested $4.1 million in tax savings that, based on a reasonable rate of return, would generate about $31 million in assets over a lifetime. So when we suggest millions of dollars are wasted by failing to structure your Personal Financial Enterprise with taxes in mind, it’s for good reason.
What we want to eliminate for our clients is overpaying their tax bills because they’re hesitant to take controversial positions (oftentimes there simply isn’t a clear answer for the position either way), or they haven’t structured their personal wealth with taxes in mind. There’s so many areas of business and life that’s affected by taxes, it creeps into nearly everything. Conversely, taxpayers have a ton of vehicles at their disposal to plan and mitigate their tax burden.
These vehicles are all pieces of a strategic, long-term tax plan. Your plan is essentially a formula. It codifies your Family Wealth Enterprise — your assets, your wealth — and defines its structure by determining how cash flows to and from entities within your enterprise. This overarching, long-term approach makes events like the recent proposed tax increases one factor in a much larger equation.
Each year, there are new wrinkles to consider, but the formula remains. It’s like a football team’s offensive scheme. It’s installed months before the season starts. If the offense is complex and the install thorough, game plans can be versatile and there are predetermined strategies in place to account for unexpected counters by the defense.
Audibles are built in, counters of our own are necessary. But the fabric of the plan doesn’t change.
Tax Rates Are Not Regressive
Because the proposed tax hikes are getting a fair amount of news coverage right now, let’s also revisit the progressive nature of your tax bracket. In our whitepaper on tax mitigation, we took a deep dive into how tax rates apply to your earnings. It’s proven relevant. We often hear of taxpayers who decline income in order to avoid going to the next tax bracket.
Don’t do that.
Tax rates are marginal and progressive, not regressive. This means there is no blanket tax taken on your entire income. It doesn’t work that way. If you’re a higher income taxpayer, yes, you pay more taxes than a lower income taxpayer. But, as a taxpayer progresses through the various rate brackets, those in the higher income brackets still enjoy the lower rate brackets on their lower levels of income earned.
As it applies here, this gives us two things to cling to:
- Never refuse additional income to avoid moving up in the tax bracket.
- Whatever tax hikes may be awaiting a wealthy taxpayer, these higher rates do not apply to every dollar earned annually.
Thomas Edison said, “Opportunity is missed by most people because it is dressed in overalls and looks like work.” The U.S. tax system is daunting and complex. And the planning that goes into creating an enterprise structure that’s capable of significant tax savings requires work.
It’s not the type of work that’s dressed in overalls. Instead, the work looks like planning and organizing and thorough documentation. It’s about having the answers to the test, and knowing the questions before they’re asked. And it’s about expertise.
You’ll want to work with an advisor that not only has a deep understanding of tax law and tax compliance, but a proven record of planning for how your Family Wealth Enterprise interacts with tax laws. The balance of being legally compliant while achieving tax savings is couched in these interactions.
If you’d like to take a deeper dive into how to create a structured tax plan for your private wealth, you’ll find more on that along with a host of other tax-related strategies like some of the misconceptions surrounding tax-deferred retirement plans and the paradox of spending a dollar to save 40 cents in “You Think You Have a Tax Plan” published on the Addicus website. Or, if you’re looking for an advisor to bring clarity to your personal financial strategy and structured tax plan, contact us.