Biden's tax increases: Drama in the shifting state of play

Tensions are flaring in Washington, D.C., over raising taxes on the wealthy.

President Joe Biden needs steep tax increases in order to bankroll his $3.5 trillion spending plan for social programs like education, child care and expanding Medicare. While his $1 trillion infrastructure plan to build roads and bridges has bipartisan support and would be paid for by shoring up an estimated $630 billion in unpaid taxes, it recently became a negotiating chip for the much larger social spending proposal. The flashpoint now on display as the horse-trading gains steam this month: Some Democratic lawmakers may not be entirely on board with the administration’s tax increases.

Bloomberg News

Which leaves financial advisors and their wealthy clients with potentially less certainty about how to plan for taxes in their long-term investments and retirement portfolios.

Here’s what you need to know now:
In late August, Democrats in the House and the Senate found a constitutional but complicated way to try to force through both trillion-dollar plans without support from Republicans. This week, lawmakers in the Senate Finance Committee and House Ways & Means Committee are set to begin drafting the nuts and bolts of the $3.5 trillion bill, including those all-important increases in individual and capital gains rates. The timeline is ambitious: The two chambers are aiming for their versions of the bill by Sept. 15, with a vote by Oct. 1.

But with Republican opposition and Democrats controlling Congress by a razor-thin margin, all 50 Democratic senators and nearly all House Democrats need to be in favor of the tax hikes embedded in the larger plan. Corporate rate increases are also on the table, but it’s the individual provisions that matter most to advisors and their clients.

Are Democrats’ “tax-the-rich dreams” really fading as Democrats race to shore up support, as The Wall Street Journal put it on Sept. 5? The separate infrastructure bill, already approved by the Senate, comes up for a House vote on Sept. 27. It isn’t being voted on in tandem with the $3.5 trillion bill, which leaves the latter more vulnerable to horse-trading.

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Here’s where things stand now for individual taxpayers, along with the spanners in the works:

Individual tax rates 
Biden wants to raise the top ordinary rate to 39.6% — where it was before the 2017 tax cuts — from the current 37%. Nobody has objected to that. So ready or not, it appears that higher federal taxes for the richest are coming down the pike.

Married couples making at least $509,300 and individuals making at least $452,700 next year would pay the higher rate. Currently, those paying the top 37% rate make $628,300 and $523,600, for joint filers and individuals, respectively. So more people would be hit by the higher rate. Those making $628,300 would pay an extra $5,474 in federal tax each year, according to Merrill Lynch. People earning $1.5 million would pay about $28,138 more.

Capital gains rate
For a taxpayer with adjusted gross income over $1 million, Biden wants to nearly double the top rate for long-term capital gains — on investment profits made after one year — to that same 39.6%, plus 3.8% for the Affordable Care Act levy. The combined 43.4% rate would be nearly double the current 23.8%. And it applies to both married couples and individuals, as we previously reported here.

But an increase that large may not materialize. Bloomberg reported right before the Labor Day weekend that around one-third of Democrats on the House’s tax-writing Ways & Means Committee are pushing for a lower capital gains rate of around 28%. Which means that Biden’s spending plans would either have to be scaled back or financed through deficits. Either way, expect more negotiating this fall before a final bill becomes law.

What kind of dealmaking? 
Democrats on the Senate Finance Committee recently began circulating a menu of options, according to a four-page document reported by NBC News on Sept. 3. Some of them will cheer advisors, while others will frighten them.

On the Senate Finance menu is Biden’s capital gains increase for high earners. But its details were scarce and potentially scary. The document agreed with Biden’s top 39.6% rate (plus 3.8% for the Obamacare levy). But it added that “the capital gains rate would be conformed to the top individual tax rate for high-income taxpayers (those in the top tax bracket).”

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Under Biden, the capital gains increase would hit earners making at least $1 million. But his new top individual rate, as we saw above, would hit married couples making at least $509,000 ($452,700 for individuals).

With the capital gains increase already polarizing and controversial, it seems unlikely that the Senate Finance option would hit even lower-income levels with a higher capital gains rate. The document didn’t say what the rate would be.

Inheritances
On the good news front for advisors and clients, the Senate committee proposed increasing the level at which individuals who inherit assets wouldn’t owe tax on the assets’ prior gains.

Biden wants to end that “step up in basis” — which eliminates capital gains tax on the prior appreciation of inherited assets — for people with adjusted gross income of $1 million or more, a threshold that would hit scores of individuals who inherit homes or small businesses. The Senate Finance Democrats’ option is a higher level of $5 million per person ($10 million per married couple), with an additional $500,000 per-couple exemption for principal residences. “Conversations continue with various offices about the design of a family farm exception, which would provide an exemption for the first $25 million in family farm property,” the document also said.

New tax hikes
In suggestions that will unnerve advisors, the group also proposed forcing billionaires to pay taxes on unrealized capital gains, a process known as “mark to market”; tightening up rules on trusts used by the wealthy to pass money to heirs; and restricting the 20% pass-through deduction to exclude those making more than $400,000, including wealthy partnerships that have taken advantage of it.

They also proposed bringing an end to mega retirement accounts, like those owned by billionaire investor Peter Thiel, by requiring their owners to distribute account balances that exceed certain unspecified thresholds.

Pushback
On another front, Senator Joe Manchin, a centrist Democrat from West Virginia, roiled the waters on Sept. 2 when he unexpectedly called for a “strategic pause” to Biden’s $3.5 trillion plan in a Wall Street Journal opinion. Citing his concerns about the national debt ($29 trillion), inflation and long-term fiscal responsibility, Manchin compared Democrats’ race to pass tax increases to Republicans’ rush to pass steep tax cuts in 2017, when the tax code was overhauled for the first time in a generation.

Bloomberg News

Manchin’s vote is needed to pass the plan, and, thus, to approve its tax hikes. The day before the Labor Day holiday, White House Chief of Staff Ron Klain told CNN that Manchin was “very persuadable” and could be brought around to Biden’s plan.

It’s not over until it’s over.

“The increase in the top individual tax rate has the broadest support among Democrats — and therefore the best chance of being approved,” Schwab wrote in an Aug. 20 note.

By contrast, changes to the capital gains rate and basis step-up rule “are not yet universally embraced by all Democrats on Capitol Hill” and will be the subject of intense negotiations. The upshot, Schwab said: “There’s a good chance that what emerges, if anything, will look very different from what the White House has initially outlined.”