Editor’s note: The tax change proposals mentioned in Legally Speaking this month currently are under discussion by members of Congress in Washington, D.C. According to John McClelland, Ph.D., American Rental Association (ARA) vice president for government affairs and chief economist, many of the provisions discussed in this article may never be passed into law or implemented. ARA always suggests that you consult your personal accountant, tax advisers or lawyers before taking any action as individual circumstances can vary.
Question: I keep hearing about upcoming tax increases, but I don’t have time to follow all the changes in the tax laws. Can you summarize what’s happening and how it might affect my equipment business?
Answer: A great many changes to taxes already have been proposed, and a great many more probably will be before the current administration is through. So, I won’t be able to provide a comprehensive summary, of course, but I can provide some highlights with respect to issues I think are likely to be important to equipment dealers and lessors.
As I’m sure you’ve heard by now, with the current administration’s addition of $1.9 trillion in coronavirus relief spending — of which approximately 8.5 percent has been allocated to coronavirus (COVID-19) health-related issues — along with $1.8 trillion in a proposed spending package for families, and $2.3 trillion in infrastructure spending, a total of roughly $6 trillion — $18,181 per U.S. citizen — of new federal spending is on the table, and that figure could grow. For context, in inflation-adjusted terms, the current proposals equate to a bit more than eight times the cost of Franklin D. Roosevelt’s “New Deal.”
Paying the piper. These outlays must, of course, be paid for. Because the government already was operating at a deficit of about $2.3 trillion, the required funds may have to come largely from tax increases and/or elimination of tax exemptions and deductions. The other options, further running up the national debt — currently $22.5 trillion — and printing money, while less painful initially, tend to devalue the dollar, risking runaway inflation.
What the piper costs. Assuming that tax increases are, indeed, on the horizon, what are we to expect? Though a number of factors, including gross domestic product (GDP), the unemployment rate, the general state of the economy, and of course, politics, will continue to bear heavily on what is, at best, an evolving process, here are some of the issues currently up for debate:
- Corporate income tax. President Biden originally proposed increasing the U.S. corporate income tax rate from 21 percent to 28 percent. This has since been walked back to 25 percent as a result of some political maneuvering, including importantly, the fact that Sen. Joe Manchin (D-W.V.), a necessary vote, has advocated for a reduced increase. Though a 25 percent rate would approximate the world average — currently 23.85 percent — fear of capital flight exits by wealthy individuals and corporations to tax haven jurisdictions such as Bermuda, the Cayman Islands, the Isle of Man and others that have zero or near-zero corporate tax rates also can impact the outcome. In fact, mechanisms such as inversions — where a corporation restructures so that the current domestic parent company is replaced by a foreign parent in a low-tax jurisdiction, thereby changing its tax domicile, despite the fact that it remains majority-owned by U.S.-based shareholders, may again become the order of the day. Certainly, there is a reason more than 80 percent of the world’s hedge funds are located in the Cayman Islands, rather than New York, London or Hong Kong. Ultimately, I expect to see a corporate tax increase, but given the competitive landscape for capital, I would be surprised if the final rate were to exceed 25 percent.
- Capital gains taxes. Taxes on investment gains on stocks, bonds, physical assets, real estate, etc., could increase substantially. Currently, long-term capital gains — investments held for more than one year — are taxed at 0, 15 or 20 percent, depending on the income level of the taxpayer. The Biden administration is proposing that such gains be taxed at ordinary income tax rates — currently 10 to 37 percent, depending on income level, though the top rate may be increasing to the previous Obama-era rate of 39.6 percent. After adding the 3.8 percent Affordable Care Act surtax on higher-income investors, as well as state taxes where applicable, taxpayers in high-tax jurisdictions such as New York and California could wind up paying out more than 50 percent of their investment gains in taxes. Almost as important as the amount of the rate increase will be the effective date of such increase — the fear being that a date announcement could spark a wave of panic selling by those seeking to get out under the old regime, before their capital gains taxes nearly double. Such fire sales could substantially depress asset prices and, among other things, trigger a series of financial defaults based on, for example, capital calls and/or asset value and debt ratio covenant breaches. Among the best examples of this was the savings and loan (S&L) crisis of the late 1980s, triggered by a host of factors, including a change in the U.S. tax code which resulted in massive devaluations of real estate that had been financed by domestic S&Ls. When borrowers defaulted and walked away, the S&Ls were left holding billions of dollars of devalued real estate they were forced to then attempt to liquidate into an already-shattered market. The result was a collapse that resulted in the closure of nearly a third of the 3,234 S&Ls in the U.S. between 1986 and 1995, and impacted virtually every sector of the economy, including the stock market, which on October 19, 1987 — known as Black Monday — lost 22.6 percent of its value, the largest single-day drop in history to that point. Nonetheless, I do expect to see a substantial increase in the capital gains rate if for no other reason than that it is likely to be among the least objectionable alternatives for many. According to the Tax Policy Center, 75 percent of all long-term capital gains in the U.S. are reported by the richest 1 percent of Americans.
- 1031 exchanges on the chopping block. As you probably know, the 2017 Tax Cuts and Jobs Act (TCJA) eliminated Section 1031 of the U.S. Internal Revenue Code exchanges with respect to equipment. Section 1031 had previously enabled investors in equipment and real estate to defer capital gains and depreciation recapture on both of these types of assets if the applicable sale proceeds were promptly reinvested in like-kind replacement assets. With the TCJA’s enactment, Section 1031 was scaled back to include only real estate investment transactions. The loss of 1031 deferral on equipment was, to some extent, offset by Section 179 and bonus depreciation, but the ability to defer capital gains on real estate remained in place and continued not only to allow sellers to limit their taxes, but also to support real estate values, in as much as real estate investors have long factored such deferrals into their purchase calculations. The proposal now on the table would eliminate this deferral with respect to real estate gains exceeding $500,000. The fear is that such a limitation, coupled with the aforementioned increase in the capital gains tax rate, could put a stake in the heart of a commercial real estate market already reeling from COVID-19-driven collapses in the office, convention and retail sectors. Again, however, depending on the extent to which this deferral mechanism is perceived to be a tax break for the rich, some form of limitation on real estate 1031 exchanges may be in the offing, a prospect that should be factored into purchase, sale and development/improvement decisions made by owners and prospective purchasers of real estate, at least until a final decision is made on whether and to what extent 1031 exchanges will survive.
- Possible imposition of capital gains tax on estates. Presently, any gain on an asset held at death normally is eliminated by stepping up the basis of the asset — the effective cost of the asset, which can then be deducted from the proceeds received upon sale of that asset in order to determine the net gain which taxes will be due — to its fair market value on the date of the owner’s death. This seeming loophole is, however, generally viewed as a trade-off for the estate tax. In other words, if the basis step-up were to be eliminated, the same gain could be subject to double-taxation — i.e., capital gains tax and estate tax, upon the owner’s passing, yielding, at least theoretically, a maximum total tax of more than 100 percent in some cases, after factoring in state taxes of up to 20 percent. Nonetheless, the administration’s proposal would, in fact, eliminate the basis step-up without touching the estate tax. The immense resulting impact on generational wealth transfers would be mitigated to a limited degree by a few carve-outs, such as the exclusion of the first $1 million of gains or $2 million for married couples, and an exemption from the capital gains tax for family-owned businesses that continue to be operated by the decedent’s heirs. This family-owned business exemption should be top of mind for many in the equipment industry if this proposal makes further headway, and I would highly recommend discussing potential outcomes with your financial planner, tax attorney and certified public accountant (CPA) if it shows any sign of becoming law. On that note, as of now, it is far from clear whether it will. This proposal, which would effectively unwind a century-old rule in the Internal Revenue Code, seems unlikely to pass muster in its current form, and may indeed be scrapped entirely in favor of simpler, less politically charged alternatives. For example, the need for such a sweeping change might be largely eliminated merely by making the estate tax more aggressive, thereby avoiding the legal and tax ramifications of eliminating the basis step-up. This will doubtless be the subject of considerable debate in the coming months, but for reasons similar to those involved in the decision to increase the long-term capital gains rate — notably, as of now, 99.9 percent of estates pay no federal estate tax — I suspect that we are more likely to see an increase in the estate tax rate — the top marginal estate tax rate is currently 40 percent, but the average effective rate is closer to 17 percent, though as noted earlier in this article, 12 states and Washington, D.C., also impose estate and inheritance taxes of as much as 20 percent, coupled with a decrease in the lifetime gift exclusion which currently stands at $11.7 million per person. Notably, the 2018 increase in that exclusion is scheduled to sunset in 2025 — meaning it will then revert to its 2017 level of $5.49 million.
Possible outcomes. Given that most business owners and investors tend to make economically rational decisions, I would expect a number of things to begin happening over the next few months, to the extent they haven’t already done so, including substantial increases in:
- Offshore investing.
- Corporate inversion.
- Individual and corporate relocations from high-tax jurisdictions such as New York and California, to low-tax jurisdictions like Texas and Florida.
- Retirement planning and savings — think 401(k) plans and IRAs.
- Sales of substantially appreciated assets in the near term — before the new tax increases become effective, which may result in a near-term market decline.
- Demand for tax-free vehicles such as municipal bonds, tax-exempt mutual funds and ETFs.
- Demand for other inflation hedges, such as metals and other commodities, real estate/REITs factoring in risk to 1031 exchanges, treasury inflation-protected securities (TIPS), and cryptocurrencies.
- Estate planning adjustments, including enhanced use of trusts and life insurance policies.
Of course, all of these are likely to coincide with reductions in savings, asset sales and investments in inflation-sensitive areas such as fixed income securities — bonds, treasuries and CDs — and to some degree, riskier investments in small companies — think of capital investments in startups and early-stage companies, which tend to decline when the net after-tax rewards are reduced relative to the same or similar levels of risk. Ironically, large company investments, by contrast, tend to do well during periods of high inflation. Given that 99.7 percent of U.S. employers are small businesses, the mid-to-longterm impacts on employment and the overall economy could be significant.
In the final analysis, although it may be impossible to avoid the impending wave of spending and tax increases, it is certainly possible to make some preparations for them, and by doing so, limit their effects to a degree — if you can just find a way to sift through and interpret all of the new regulations while continuing to run your business. Perhaps most importantly, if double-taxation of estate assets actually does become a reality, owners of family-run businesses may need to make substantial adjustments to their estate plans in order to ensure their heirs can actually afford to inherit their businesses.
James Waite is a business lawyer with more than 25 years in the equipment rental industry. He authored the American Rental Association’s book on rental contracts and represents equipment lessors throughout North America on a wide range of issues. He can be reached at 866-582-2586 or james@jameswaitelaw.com.