Tax Planning by Accelerating Gain Recognition into 2020

14 October 2020 2020 Election Resource Center Blog
Authors: Stephanie J Derks Jason J. Kohout

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As part of his campaign platform, Democratic Presidential nominee Joe Biden has released a tax plan which may significantly increase the capital gain tax. Specifically, the platform includes a proposal to eliminate the preferred 20% rate on long-term capital gain and qualified dividends for taxpayers with more than $1 million in taxable income. Instead, under the Biden plan, this type of income would be subject to tax at ordinary income tax rates, with the highest bracket ordinary income tax rate returning to the 39.6% rate in effect prior to the Tax Cuts and Jobs Act of 2017.  If this proposal is adopted wholesale, it would mean that capital gains subject to a 20% tax rate if recognized in 2020, could perhaps be subject to nearly double that tax rate in 2021 or 2022 (or later).

See here for an outline of the Biden proposals affecting high net worth individuals.

For our analysis of the likelihood of whether these rate increases occur effective to January 1, 2021, see here. Foley will host a post-election webinar on November 10th with three former Congressman to provide some insight as to what the election outcome will mean for policy.

Generally, effective tax planning calls for deferring the recognition of income for the longest possible period.  However, in the case of tax rate increases, a taxpayer may save income tax by accelerating income tax due and paying sooner but at a lower rate. Taxpayers should be cautious before accelerating income tax gain and measure the potential opportunity cost of paying tax early. By paying tax earlier, the taxpayer will not have the investment returns from funds used to pay the tax because the dollars used to pay the tax are no longer available for investment. The value of this opportunity cost depends on the amount of time, and certainty, of when the taxpayer would otherwise recognize and pay the tax, the rate of tax in the later year, and the investment returns forgone in the interim period.  If a taxpayer recognizes income that could otherwise be deferred for several years, the taxpayer may find that under usual assumptions of investment growth, the taxpayer would be better off deferring the gain and paying the income tax at a higher rate (this is because recognizing gain now requires that the tax is paid now and dollars used to pay the tax are no longer available for investment). Given some reasonable assumptions, if income rates go up dramatically, the break-even point (between acceleration into 2020 and deferring the tax) is about 4-6 years. If rates go up only modestly, the break-even point is about 2 years.  If a recognition event is highly certain within three years, a taxpayer might consider accelerating the gain into a low rate year. These can be highly specific calculations.

If a taxpayer is interested in accelerating the gain and paying the income tax in 2020, there are a number of ways to cause the recognition of gain: 

  • For those taxpayers who own highly appreciated publicly-traded stock, the taxpayer can simply sell and then repurchase the securities. The “wash sale” rule of Section 1091, which generally disallows losses when a shareholder sells securities for a loss and repurchases the same or substantially identical stock or securities, does not apply to disallow recognized gains.

  • Taxpayers who make installment sales in 2020 may elect out of installment sale treatment (causing all of the gain to be recognized in 2020 as opposed to be deferred until the future).

    Taxpayers who sold a company and reported part of the purchase price as an installment sale in prior years can generally accelerate the recognition of the capital gain on the installment sale by either pledging the note as security for a bank loan (which generally accelerates immediate recognition up to the amount of loan proceeds), or by selling, gifting, or exchanging the note. For example, taxpayers may consider gifting or selling the notes to a non-grantor trust, which would cause the gain to be recognized.
     

  • For taxpayers with closely-held business interests, with expectations of selling such business interests in 2021 or 2022, there are a number of ways to recognize the gain at today’s 20% rate, thereby generating basis that can be used to offset gain against sale proceeds in the future (which such proceeds may be taxable at the 39.6% tax rate):

    • Non-grantor trust:

      • If the taxpayer sells the stock or LLC interests to a non-grantor trust, the sale will trigger income tax recognition. Once the stock or interests is sold to the trust, the stock or interests will also receive a new basis, equal to the purchase price.Section 267, which disregards certain losses between related taxpayers, does not apply to recognition of gain between related taxpayers, consequently allowing the sale to the non-grantor trust to trigger gain.

      • The trust, which may have limited liquidity, can purchase the interests with a note.If so, the taxpayer should elect out of installment sale treatment. The taxpayer will only receive the proceeds for the business interest up to the sale price (the later third party sale price may be more).

      • In addition to achieving the goal of accelerating gain, this type of transaction may have estate tax benefits as well. The beneficiaries of the trust could be the grantor’s children. If structured correctly, the difference between the sale price between what the taxpayer paid the trust and what the third party pays the trust for the stock in a future year would not be subject to estate tax at the grantor’s death.

    • Self-Settled Trust: If the taxpayer wants to retain more of the economic benefits of a stock or LLC interest even after a sale, the taxpayer may sell the stock or LLC interest to a self-settled trust. Sales to self-settled trusts allow the grantor to be a beneficiary of the trust (and be able to access the proceeds of the sale), while also triggering gain on the sale to the trust.

    • Conversion to LLC: Owners of an S-corporation may trigger gain by legally converting from a corporation to an LLC. Converting to a LLC will cause a liquidation/recognition event.

    • Finally, there are additional creative ways to trigger recognition. For instance, a taxpayer may be able to look to section 721(b), which causes gain on the funding of a partnership that would otherwise constitute an investment company.
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