- A 50/50 split Senate increases the odds that some elements of President Elect Biden’s agenda could be implemented, but the more progressive parts of his plan are unlikely to make significant near-term headway
- Although the possibility of higher taxes hangs over the market, the potential for higher fiscal spending is providing an offset
- While the likelihood of the most impactful proposals of President Elect Biden’s tax plan passing in 2021 is slim, certain proposals that have broad support, such as increases to corporate and top income tax rates, are more likely to succeed
- Retroactive tax legislation is possible but unlikely. For those concerned about this possibility, incorporating flexibility into wealth transfer planning is key
- Irrespective of recent election outcomes, current federal tax rates are relatively low, and key provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) are scheduled to expire. Given these dynamics, several tax planning strategies merit consideration
- We continue to recommend staying diversified — across geographies and sectors — and ensuring appropriate levels of Risk Control assets
Democratic candidates Raphael Warnock and Jon Ossoff have won their respective Senate races in Georgia, bringing the makeup of the new Senate to 50 representatives per party — with Democratic Vice President Elect Kamala Harris holding a tiebreaking vote. While this result indicates a heightened possibility of passing key initiatives of President Elect Biden’s agenda, the political reality could be more complex than it might appear, as the narrow margins of victory also suggest the possibility of continued relative gridlock. Importantly, we believe that it will remain difficult to make meaningful headway on some of the more progressive elements of the Biden agenda, as more moderate Democrats — notably, West Virginia Senator Joe Manchin — have publicly voiced opposition.
Market and Macro Takeaways
President Elect Biden’s stated plans entail meaningful increases in fiscal spending — including additional COVID-19 relief and large infrastructure spending — funded by tax increases impacting wealthy households and corporations.
It is certainly possible that there could be action on the tax front for corporations, and in any case, it is probable that the specter of higher taxes will hang over the market. That said, the growth impulse coming from potentially higher fiscal spending — particularly as we are experiencing a surge in COVID-19 cases and hospitalizations across many large cities and states — may provide more than an offset to those fears. President Elect Biden’s “Build Back Better” plan includes $3T in additional fiscal spending, and although it is unlikely that such a sizeable package gains broad support, there is bipartisan support for more stimulus — as well as for infrastructure spending. Investors may embrace additional government spending in an environment where the Federal Reserve has committed to “letting it ride,” leaving monetary policy extremely accommodative, even in the face of better data on the growth and inflation fronts. In short, elements of President Elect Biden’s agenda on taxes and spending could pass with a simple majority through reconciliation — the same process used to pass the George W. Bush tax cuts in 2001-2003, key aspects of President Obama’s health care agenda, and President Trump’s recent tax cuts — but this will rely on engagement with moderate Democratic Senators.
A 50/50 split in the Senate also gives President Elect Biden an advantage in obtaining approval for his nominees to key positions, increasing the odds that more progressive candidates are approved for key regulatory positions. This may encourage investors to reprice regulatory risk around the energy sector and some key technology companies. Healthcare will almost certainly be on the front burner as well, with a focus on access and affordability.
As we write, the whirring Wall Street calculators are doubtlessly at work to determine the potential hit to bottom line earnings under a higher tax regime (note: we have determined a 7% decline in net income for the S&P 500 under the Biden corporate tax plan). However, the initial overall market reaction has been generally positive. Small caps in particular have rallied, being a cohort more geared to an increase in U.S. growth. We would also anticipate a rotation toward companies sensitive to increased spending on green infrastructure and alternative energy, although it is important to note that many of these stocks have already priced in quite a bit of good news.
The most acute reaction has been in the bond market, as investors begin to price in an environment of potentially stronger growth and higher inflation. The 10-year Treasury has breached the 1% level, and the yield curve sits at the steepest level in several years. Inflation breakeven rates, as well as forward rates, also confirm expectations for higher inflation. This will be the most important data point to watch. Although we remain committed to our “Stuckflation” theme, whereby we anticipate inflation to remain low, we see increasing potential for an upside surprise over the near term, with higher fiscal spending colliding with the anticipated spring/summer economic reopening. We amended that theme in 2021 to "Stuckflation tested," and that seems particularly apt given the Georgia outcome.
Importantly, we believe that the Fed will be slow to react to any change in the inflation outlook, which will keep real yields negative across the yield curve. Monetary policy will remain accommodative, and it is possible that the Fed could intervene should bond investors drive yields too far, too fast. The Fed could modify its quantitative easing program in size or duration in order to better control interest rates across the curve and avoid a disorderly re-set higher in rates.
For investors, we are not recommending taking action based on the outcome of the Georgia runoffs. Changes in tax legislation, as well as additional meaningful fiscal spending, require a majority, and even with the “Blue Sweep” and Vice President Elect Harris’s swing vote, Democrats hold the slimmest of advantages — which may not be enough to change the gridlock-type outcomes we have experienced recently. Further, many Democrats in the Senate will be looking carefully and cautiously toward the mid-terms in 2022, potentially heightening reluctance to support drastic changes. As always, it will be incredibly important to stay diversified within your Risk Asset portfolio — across geographies and sectors. Also, we continue to recommend a careful assessment of your Risk Control portfolio to ensure you have the appropriate level of high quality relatively short duration core fixed income and cash to fund near-term goals as well as provide a portfolio buffer against volatility.
The likelihood that all of the most impactful proposals of President Elect Biden’s tax plan, referenced below, will pass in 2021 is very slim. The 50-50 Senate result means Democrats must achieve complete unity in order to pass legislation. Consequently, proposals that have broad support among moderate Democrats, such as increases to the corporate tax rate and top income tax rates, are more likely to succeed. Revisions to previous laws, such as lowering the estate-tax exemption prior to the planned expiration, may also be more feasible.
It should also be noted that as a result of the sweep, there is no longer a 0% chance of retroactive legislation, as unlikely as that may be. For those who are concerned about retroactive legislation, incorporating flexibility into wealth transfer planning takes even greater priority.
Key provisions of President Elect Biden’s proposed tax policy include:
- Raise the top individual rate for those making more than $400,000 from 37% to the pre-TCJA rate of 39.6%, and raising corporate rates from 21% to 28%
- Increase tax on long-term capital gains and qualified dividends to 39.6% for investors with income over $1 million, nearly double today’s top rate of 20%
- Impose a 28% cap on the value of itemized deductions and reinstate the phase-out of deductions, referred to as the “Pease Limitation,” for top earners
- Eliminate the “step-up” provision for estates. Currently, the cost basis of assets is “stepped-up” to fair market value as of date of death, resetting the tax basis to fair market value
- Potentially return estate taxes to “historical norms.” Proposals made during the Obama administration could resurface, including a 45% tax rate and a lowering of the higher exemption of $11.58 million sooner than its planned expiration in 2025, perhaps to as low as $3.5 million
Wealth Planning Strategies
Consider Tax Diversification
To hedge against potential income tax increases, consider identifying areas to accelerate income or pair down a concentrated position in order to take advantage of historically low income tax rates. Additionally, tax diversification strategies — consisting of a mix of taxable, tax deferred and nontaxable accounts with varying rules for taxation and withdrawals — can help mitigate the impact of higher future tax rates. For example, coordinate taxable and tax-free withdrawals to minimize income taxes in retirement through ownership of both traditional IRAs and Roth IRAs.
The new stimulus package passed at the end of 2020 extends many of the charitable giving provisions of the CARES Act for an additional year. For those who itemize, consider accelerating future planned charitable contributions into 2021 in order to take advantage of the provision of the CARES Act that temporarily suspends caps limiting charitable contributions of cash gifts.
Take Advantage of Incentivized Opportunities
Capital gains mitigation strategies remain a top priority for many. Qualifications for the two strategies discussed below are nuanced, and the benefits and drawbacks must be examined — but given the correct qualifications, the tax savings could be substantial.
The qualified small business stock (QSBS) exclusion allows founders, employees and investors who own stock in qualifying small businesses an exclusion from capital gains when they sell their stock given certain eligibility and documentation requirements are met. For example, if you invested $2 million in a QSBS, you could sell that stock five or more years later for up to $22 million and pay zero federal income tax on that gain — a savings of almost $5 million at today’s rates. President Elect Biden has not proposed any changes to the existing QSBS exclusion, but any future increase in capital gains tax rates may enhance the benefits of the exclusion.
Similarly, other tax code provisions allow suitable investors to achieve tax savings by investing in qualified opportunity funds (QOFs). These funds, which invest in distressed communities (“opportunity zones”), may result in a deferral or even exclusion of the capital gains upon sale, depending on the duration of the investment. President Elect Biden supports maintaining the benefits of QOFs but has called for reforming regulations to ensure funds benefit underserved communities and prevent abuses.
Estate Planning Strategies
Gift to Flexible Trusts
Families who have a high probability of achieving their goals should consider utilizing their lifetime exclusion now in order to shift future appreciation out of their estates and avoid losing the larger, expiring exclusion amount. Utilizing trusts provides an opportunity to choose a trustee to make investment and distribution decisions, limit creditor access to assets, and gain tax planning advantages. Married couples positioned to meet lifetime goals could consider making a spouse a beneficiary of a trust in order to provide flexibility for future use of assets for the family.
Utilize Freeze Strategies and Intra-Family Loans in the Low Interest Rate Environment
Families who have a high probability of achieving their goals should also consider utilizing “freeze” strategies to mitigate the appreciation of assets. These approaches are likely to be very effective for the tax-free transfer of wealth in this historically low rate environment. They include funding trusts such as grantor retained annuity trusts (GRATs), selling assets to intentionally defective grantor trusts (IDGTs) and making intra-family loans. The tax savings effectiveness depends on the ability of assets gifted to appreciate faster than the very low interest rates currently prescribed by the IRS. If funding the trusts with stock or business interests, depressed valuations improve the opportunity to capture significant appreciation over the next several years.
Additionally, intra-family loans may be attractive in the current environment, allowing the deployment of capital at virtually no cost to family members. Existing intra-family loans also could be refinanced at current extraordinarily low rates.
Note there is a chance that, as we saw under President Obama, we could see regulations curtailing popular planning techniques, such as valuation discounts and GRATs.
The Right Strategies for You
We reiterate our theme that the best tax planning is guided by your long-term goals, regardless of political outcomes — and that when it comes to wealth planning, incorporating flexibility is key. To discuss strategies such as those addressed above and ensure you are positioned to achieve your goals, please contact an advisor.