By Robert Klein, CPA
Located at the end of President Biden’s American Families Plan released on April 28th is the administration’s wealth redistribution plan titled “Tax Reform That Rewards Work – Not Wealth.” The section begins with the statement that the goal is to reverse provisions of the Tax Cuts and Jobs Act of 2017 and reform the tax code “…so that the wealthy have to play by the same rules as everyone else.”
Proposed Lifetime and Death Capital Gains Tax Rate of 43.4%
The American Families Plan would increase the top marginal income tax rate from 37% to 39.6%. In addition, the proposed top rate of 39.6% would replace the current long-term capital gains tax rate of 20% for households with income over $1 million. While income at this level is not the norm (539,000 income tax returns were filed in 2019 with 2018 adjusted gross income of more than $1 million, representing 0.4% of 141 million total returns filed), it is not unusual for business owners to cross the $1 million threshold when they sell a business.
Long-term capital gains tax rates for households with income over $1 million would almost double under President Biden’s plan, increasing 19.6% from 23.8% to 43.4% when you include the net investment income tax of 3.8%. Let us not forget about state income tax. Add on 13.3% if you live in California for a total marginal tax rate of 56.7% on all income, including long-term capital gains.
The proposed legislation would also eliminate the step-up in basis on unrealized gains exceeding $1 million at death. The step-up in basis allows individuals with appreciated assets to avoid income taxation on the appreciated value when they die. Unrealized gains exceeding $1 million at death would be taxed at a 43.4% rate unless the appreciated assets are donated to charity.
Eliminate Capital Gains on Business Sales with a CRT
Lifetime charitable giving has historically benefited individuals with highly appreciated non retirement assets such as real estate, investment portfolios, and businesses. Many savvy business owners who are planning on selling their business and want to reduce or eliminate income tax liability attributable to the capital gain that they will realize from the sale can use a long-standing IRS-blessed strategy called a charitable remainder trust, or CRT. A properly designed and administered CRT managed by an experienced investment advisor who specializes in CRTs and is familiar with their four-tier payout scheme can be used as the cornerstone of a successful business owner’s retirement income plan.
A CRT is a tax-exempt trust. The initial and one of the most important benefits of a CRT is that the gain on the sale of assets owned by a CRT is exempt from taxation. This includes ownership of a business interest.
Tax Proposal Creates Sense of Urgency for Implementation of CRT Business Sale Strategy
The proposed long-term capital gain tax rate increase of 19.6% has created a sense of urgency for business owners who are thinking about selling their businesses in the near future. The CRT strategy will increase in popularity with the proposed tax law changes. It will likely result in the acceleration of the sale of many businesses to avoid the increased tax liability attributable to long-term capital gains exceeding $1 million from the sale if the proposed changes are enacted.
It is important to keep in mind that the proposed tax legislation that’s part of the American Families Plan is in its early stages. The long-term capital gains tax rate increase of 19.6% and elimination of the step-up in basis at death are major departures from long-term fixtures of the income tax law, and, as such, are controversial and subject to modification.
Having said this, given the reality that one of the missions of the current administration is redistribution of wealth as evidenced by the fact that the American Families Plan was released on the 98th day of the new administration, successful business owners have a lot at stake and need to act quickly before the proposed legislation or some form of it is enacted. Furthermore, business owners and others adversely affected by the proposed legislation need to keep in mind that any tax legislation that is enacted, whether it is in 2021 or 2022, could have an effective date as of the date of enactment or even a retroactive date.
CRT Funding Creates a Current Income Tax Deduction
When the CRT income beneficiary(ies) die, the remainder interest in the CRT is transferred to one or more charitable organizations specified in the CRT document. This creates a second income tax benefit to the business owner, i.e., a charitable contribution deduction, that can be used to offset otherwise taxable income.
The deduction, which is taken in the year that the business interest is transferred to the CRT, is the present value of the projected remainder interest of the CRT that will pass to one or more charities. The amount of the deduction can be hundreds of thousands of dollars or more depending upon the value of the business interest being transferred to the CRT and the age of the business owner and spouse if married. The allowable charitable deduction is limited to 30% of adjusted gross income, with excess amounts carried forward for five years.
CRT Lifetime Income Stream is Tax-Favored
The third income tax benefit enjoyed by a business owner who sells part or all of his/her business interest using a CRT is favorable taxation of CRT income. The net proceeds from the sale of a business interest owned by a CRT are reinvested by the CRT to provide a lifetime income stream to a designated beneficiary who is generally the business owner and his/her spouse if married.
The periodic income payment is calculated using either a fixed dollar amount if it is a charitable remainder annuity trust (CRAT) or a fixed percentage of the annually redetermined net fair market value of trust assets for a charitable remainder unitrust (CRUT). The taxation of CRT income, which is reported annually on Schedule K-1, is driven by the character of the income being distributed, taxed in the following order under a four-tier payout scheme: ordinary income, capital gains, tax free income, and principal.
Most of a CRT’s annual income will be taxed as long-term capital gains at a current top federal tax rate of 23.8% since the origin of a CRT from the sale of a business is untaxed long-term capital gains. CRT income classified as long-term capital gains will continue to enjoy favorable tax treatment if President Biden’s tax proposal is enacted provided that total taxable income in a given year is less than $1 million.
Potential CRT Income Tax Savings – Current Income Tax Law
In summary, income tax savings attributable to establishing and funding a CRT in connection with the sale of business includes three components: elimination of the capital gain from the sale of the business, a sizable charitable contribution deduction, and favorable income tax treatment of CRT lifetime income distributions.
The latter benefit is threatened if the administration’s tax proposal is enacted and taxable income in a particular year exceeds $1 million. When this occurs, it generally happens in the year of sale. It could extend to future years if the business is sold on an installment sale basis depending upon the selling price and the amounts received in subsequent years.
The easiest way to illustrate the initial and ongoing income tax savings from a CRT is with an example. The example applies current income tax law and includes the following eight assumptions:
· Sale of business on June 30, 2021 with long-term capital gain of $5 million
· Reinvestment of net proceeds of business if sold outright with a return of 5% split 50/50 between qualified and nonqualified dividend income
· Reinvestment of net proceeds of business if sold by CRT with annual distributions of 5% of prior year’s December 31st CRT value split 75/25 between long term capital gains and dividend income, with the latter split 50/50 between qualified and nonqualified dividend income
· Other ordinary income of $200,000
· Standard deduction with outright sale
· Married filing joint tax status
· Ages 63 and 59
· California resident
Cases #1 and #2 – Outright Sale of Business
The purpose of Case #1 is to calculate the income tax liability attributable to the long-term capital gain of $5 million from the sale of the business. Per the illustration, federal income tax would be $1.143 million, or 22.86% of the gain. California tax would be $623,000, or 12.46% of the gain, for total income tax liability of $1.766 million, or 35.32% of the gain.
Case #2 includes investment income of $81,000 and other ordinary income of $200,000, increasing taxable income from $4.975 million to $5.256 million. Total income tax liability increases from $1.766 million to $1.908 million, or 36.13% of total adjusted gross income.
Case #3 – Sale of 100% of Business by CRT
Case #3 assumes that 100% of the ownership of the business is transferred to a CRT prior to the June 30, 2021 assumed closing date. This would result in the following:
· Long-term capital gain of $0
· Charitable contribution deduction of $1.422 million with allowable deduction of $97,500 in 2021, $135,000 in 2022, and the balance of $1,189,500 carried forward for four years
· Total projected 2021 income tax liability of $52,000 or $1.856 million less than Case #2 tax liability of $1.908 million
· Reinvestable net after-tax proceeds of $4.9 million, or $1.8 million greater than Case #2 of $3.1 million.
· Annual investment income of 5% of the CRT value of $5 million, or $250,000, which is $88,000 greater than the projected annual investment income of $162,000 from the net after-tax proceeds from an outright sale
· $218,750, or 87.5%, of CRT investment income of $250,000 taxed at a 23.8% capital gains tax rate vs. $80,846, or 50%, of non-CRT investment income of $162,000 taxed at a 23.8% capital gains tax rate
· Total projected 2022 income tax liability of $75,000, or $18,000 less than Case #2 projected liability of $93,000
Enactment of the American Families Plan would result in additional federal income tax liability of 19.6% of $5 million, or $980,000, for an outright sale. Without a CRT, reinvestable net after-tax proceeds of $3.1 million would be reduced to $2.1 million, or 42.2%, of the long-term capital gain of $5 million.
CRT Assets Avoid Estate Taxation
Did I mention that there is another tax bill that Senator Bernie Sanders and the White House formally proposed on March 25th called the “For the 99.5% Act?” This proposal would reduce the federal gift and estate tax exemption of $11.7 million per individual to $3.5 million effective January 1, 2022. The “For the 99.5% Act” would also increase the estate tax rate from 40% to 45% on taxable estates exceeding $3.5 million, 50% on estates above $10 million, and 65% for estates over $1 billion.
A CRT is an excellent estate planning strategy for reducing estate tax. CRT assets avoid estate tax since the remainder of the CRT passes to charity at death, and, as such, is excludable from one’s taxable estate. In the preceding example, the remainder value of the $5 million of assets transferred to the CRT would be excluded from the husband and wife’s estate.
Retirement Income Planning Essential When Evaluating CRT Strategy
A CRT is a powerful planning strategy that can be used as the cornerstone of a successful business owner’s retirement income plan. It offers the opportunity for sizable initial and ongoing income tax savings, increased sustainable lifetime tax-favored income, elimination of estate tax on CRT assets, and, last, but not least, a philanthropic/legacy component, i.e., the distribution of the remainder of the CRT to one or more chosen charities.
There are many situations where individuals who have used this strategy have accumulated a larger estate that has been distributed to their heirs than they would have without a CRT. This can occur when a CRT is combined with an irrevocable life insurance trust that purchases life insurance on the life of the business owner and his/her spouse if married using a portion of the income tax savings from implementing the CRT.
The CRT strategy, while it offers several significant benefits for business owners selling a business as well as their families, is not for everyone. The implementation of a CRT generally should not be an all or nothing proposition whereby 100% of the ownership of a business is transferred to a CRT.
It is important to strike a balance between CRT vs. individual ownership, weighing the pluses and minuses of each in a particular situation within the context of a holistic retirement income plan. Paying some income tax is not necessarily a bad thing – especially if you can do so at a federal tax rate of 23.8% vs. 43.4%.
About the author – Robert Klein, CFP
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the writer and publisher of Retirement Income Visions™, a blog featuring innovative strategies for creating and optimizing retirement income that Bob created in 2009.
Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies, including charitable remainder trusts, to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.
Retirement Income Center has established relationships with various highly respected professional organizations and platforms to provide the firm’s clients with its comprehensive array of fee-based planning, management, and protection services.
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