Details in the U.S. Treasury’s recently released Green Book offer new tax planning insights and opportunities for business owners in light of the proposed tax changes outlined in the Biden administration’s fiscal 2022 budget.
What follows are several key wealth planning strategies to consider in view of these tax proposals, which include the various corporate and income tax changes intended to help fund the American Jobs Plan and the American Families Plan. It is important to remember that these proposals represent a starting point. The political process will dictate what is ultimately adopted into law. We continue to emphasize that it is far better to plan than predict. The best strategy remains focusing on your long-term goals while retaining sufficient flexibility to accommodate the uncertain policy landscape.
Revisit the entity structure of your business
The Green Book reaffirms the Biden administration’s proposal to raise the corporate tax rate to 28% from 21%, effective January 1, 2022. Further, it includes a proposal to ensure that all pass-through business income of high-income taxpayers from limited partnerships, limited liability companies and S corporations would be subject to either the net investment income tax or Self-Employment Contributions Act tax (as well as a proposed increase in the top income tax rate to 39.6%).
Consider revisiting your business’ entity structure. Model various cash flow scenarios (C corporation versus a pass-through entity such as an S corporation or partnership), taking into account the cost and timing of converting from one entity to another, whether you plan to reinvest cash flows into the business or distribute them to your shareholders, and other tax implications, such as employee payroll taxes.
Review your business’ operating model
The Green Book includes a variety of tax credits for businesses that invest in clean energy initiatives, as well as tax credits for business expenses incurred in support of onshoring jobs. The tax plan also proposes eliminating certain tax incentives and deductions for companies with foreign operations (for example, the tax deduction for foreign-derived intangible income).
Review your business operations and workforce footprint to determine whether you might take advantage of these tax credits, if they become available, to offset any increase in corporate taxes. Also, revisit any current or anticipated sources of non-U.S. income, and evaluate the potential impact on your business’ profitability if these tax changes are enacted.
Consider when to place assets into service
The Tax Cuts and Jobs Act of 2017 increased the amount of depreciation that business owners can deduct for certain tangible assets to 100% from 50% of the asset’s cost in the year that the asset is placed into service. After 2022, the 100% decreases by 20 percentage points until it is phased out altogether in 2027. From a tax perspective, when corporate tax rates increase, depreciation becomes more valuable to corporations and to owners of pass-through entities who will be subject to higher marginal income tax rates under the Biden administration’s plan.
Consider the possibility of delaying certain large-scale capital expenditures until 2022 to increase your tax savings from depreciation if the corporate tax rate increases next year.
Personal Income Taxes
Elect installment sale treatment on sale of shares
The budget proposes increasing the capital gains and qualified dividends tax rate for those earning more than $1 million to 39.6% (+3.8% net investment income). The Green Book indicates this proposal “would be effective for gains required to be recognized after the date of announcement” (presumably April 28, 2021, the date that the administration’s American Families Plan was announced).
Many business owners have considered selling all or a portion of their business this year ahead of an anticipated increase in the capital gains tax next year. Although it is unlikely that these tax changes will be adopted retroactively, consider electing “installment sale treatment” when you sell shares of your business to provide some optionality.
In an installment sale, you would sell shares of your business (either to a third-party buyer or to a taxable trust for the benefit of your heirs) in exchange for an installment note. Capital gains tax on the shares sold would be payable over the term of the installment note as principal payments are received. If the proposed legislation is adopted with a retroactive effective date (as early as April 2021), the installment method of taxation allows you to defer the capital gains tax into future years.
If, however, capital gains tax legislation is adopted effective as of a future date (for instance, January 1, 2022), you have the option of “electing out” of installment sale treatment and triggering the entire gain at the time of the sale at the current lower rate. An election out of the installment method must be made on or before the due date (including extensions) for filing the seller’s income tax return for the year in which the transaction occurs. As such, this election out could occur as late as October 15, 2022.1
Consider taking some cash out of the business through a dividend recapitalization
If you are looking to generate liquidity but are not prepared to sell or issue additional shares, a dividend recapitalization may offer a solution. In a dividend recapitalization, the business takes out a loan and uses the proceeds to pay a one-time dividend to shareholders which they, in turn, can reinvest into other assets to establish a higher tax basis.
Paying a dividend now may help reduce the tax burden on shareholders if the tax rate on qualified dividends increases prospectively. Further, the additional debt that the business takes on will decrease the value of the shares of the business and, as a result, allow you to use up less of your available lifetime gift tax exemption when gifting shares. It can also decrease your capital gains tax exposure if you end up selling your shares. Keep in mind that these benefits will be partially offset by the interest and principal payments that the business will pay on the new debt.
Reevaluate your real estate portfolio
The administration also proposes to limit the ability to do a like-kind exchange and defer the capital gain on the sale of real estate up to an aggregate of $500,000 for each taxpayer ($1 million for married individuals filing a joint return). Many business owners invest in real estate, either as part of their business or as an investment.
Revisit your long-term investment plans for your real estate holdings and consider accelerating like-kind exchange transactions this year where appropriate. Understand the tax basis of your real estate investments, the tax implications of a taxable sale (including recapture of depreciation deductions which are typically taxed at higher rates), and the cash flow implications of selling versus holding if the tax proposal is enacted. For business owners who may be considering reinvesting proceeds from the sale of their business into real estate, reevaluate your post-sale investment plan and whether the proposed limit on like-kind real estate exchanges may require you to modify your wealth strategy in order to meet your long-term financial goals.
Gift and Estate Taxes
Consider gifting shares of your business this year
The administration’s tax plan proposes to treat transfers of appreciated property by gift or on death as realization events. Under the proposal, effective January 1, 2022, donors or deceased owners of an appreciated asset would realize a capital gains tax at the time of the transfer. This would be subject to a $1 million per person exclusion and certain additional exclusions for transfers to spouses and charities, and for family-owned and -operated businesses.
Given these proposed changes, consider using your remaining lifetime exemption to transfer shares of your business out of your estate before the end of 2021. A common transfer strategy utilized by business owners is to recapitalize the shares of the business into voting and non-voting shares, which will enable you to transfer most of the value of your business to your heirs in the form of non-voting shares, while allowing you to retain control of the business by owning the voting shares.
Also consider revisiting your ownership structure regarding how shares of your business are held, including through family limited partnerships, and ensure that you are using valuation discounts when transferring shares, as the Green Book suggests that these valuation discounts may be curtailed or eliminated after 2021.2
Stress-test your business succession plan
The Green Book indicates that payment of tax on the appreciation of certain family-owned and -operated businesses would not be due until the interest in the business is ultimately sold or the business ceases to be family-owned and -operated. Added clarification is needed to understand what constitutes a “family-owned and -operated business” and when such a business, for tax purposes, is no longer deemed to be “family-owned.”
Business owners should think seriously about implementing a comprehensive succession plan for transferring ownership of their business to the next generation to take advantage of this tax exclusion if and when appropriate. Explore our insights on building a succession plan and family governance plan, hiring and working with family, and preparing the next generation to lead the business to help you plan accordingly.