For wealthy clients, a new reality may be emerging
by Christopher DhanrajMr. Dhanraj is managing principal of investments for CLA, a professional services firm delivering integrated wealth advisory, outsourcing, audit, tax, and consulting services. Visit claconnect.com.
“Roller coaster” best describes the mobility of the economic landscape over the past year and, as we enter the fourth quarter of 2021, investors should keep a close eye on proposed federal income, estate and gift tax law changes — in addition to a number of trends. Federal tax law changes impacting wealthy individuals and couples could become reality and ultimately alter approaches to financial planning.
Tax Law Changes
Federal tax law changes proposed by the Biden administration in the American Families Plan include:
- An increase in the top individual federal income tax rate from 37% to 39.6%
- Long-term capital gains tax rate increase from 23.8% to as high as 43.4% when including net investment income tax of 3.8%
- A shift from no limit on like-kind exchanges to a $500,000 limit
- A permanent extension of limits on excess business losses
“For the 99.5% Act”
What also cannot be overlooked by investors is the “For the 99.5% Act,” a bill introduced into Congress in March 2021 by Senator Bernie Sanders and Representative Jimmy Gomez. The potential impact of this proposed legislation on federal estate and gift tax laws would significantly affect estate planning.
The proposal is so named as it has been estimated that the wealthiest 1% of Americans own nearly 32% of the nation’s wealth, compared to the bottom 50% owning 2%. The “For the 99.5% Act” seeks to reverse this trend and increase the estate tax rate currently in place. Main provisions of the proposed legislation in comparison to current law include:
- Federal estate tax exemption reduction from $11.7 million to $3.5 million
- Increase in gift and estate tax rates from 40% up to a top rate of 65%
- Elimination of the short-term Grantor Retained Annuity Trust (GRAT) with no “grandfather” exemption for existing trusts
- Grantor trust inclusion in a decedent’s estate. Many irrevocable trusts are grantor trusts for income tax purposes, although trust assets are excluded from the grantor’s estate for federal estate tax purposes. Enacting the “For the 99.5% Act” into law would end the grantor trust type of estate planning.
- Elimination of minority discounts on valuations for the transfers of non-business assets held in a business entity such as a partnership or limited liability company controlled by or majority-owned by members of the same family
- Elimination of certain marketability discounts for passive assets not used in an active trade or business
Some of these estate tax rate changes could significantly impact what are referred to as “middle-class millionaires” who will need to restructure their current estate plans if the “For the 99.5% Act” is passed into law especially given the proposed estate tax of 45% on estates above $6 million.
The “For the 99.5% Act” would provide beneficial valuation rules for small businesses and farms as well as land subject to qualified conservation easements. The act would give family farms extra protection by allowing lower assessed value on farmland up to $3 million, exempting even more farms from tax. However, there would be no discounts for non-business assets and limits would be incurred on minority interests if family owned or controlled. The legislative proposals are moving targets. The “For the 99.5% Act” is merely an illustration of the philosophical positions of its sponsors in Congress. Final legislation, if enacted, may income some provisions similar to the above.
Trends to Watch
“Cautious optimism” best describes the current fiscal landscape, given the mixed economic signals that vacillate between a bullish and a bearish market. The COVID-19 vaccine (and impending booster) roll-out, job recovery, a strong appetite for fiscal stimulus, and bipartisan infrastructure support top the list of bullish signs, while rich market valuations, growing inflation concerns, a rise in real interest rates, and volatility at the single-security level point to bearish market signals. Investors should be prepared to navigate any market environment.
Economic recovery as we’re now seeing acts as a tailwind to all industries, opening the door to rich valuations and the opportunity for value investing. This investment strategy involves picking stocks that appear to be trading less than their book value; value investors actively seek out stocks they believe the stock market is underestimating, offering a chance to profit by buying stocks at discounted prices.
Given that U.S. equity valuations are at all-time highs, investors should focus on fundamental metrics when constructing portfolios, such as free cash flow and earnings. And with rising interest rates pointing to an improving economy, there is an opportunity to invest in financial institutions that can take advantage of the increasing rates.
While private real estate sectors indicate diverging performance, Industrial has been one of the most resilient real estate sectors throughout the pandemic, buoyed by rising e-commerce demand. Likewise, investment activity in the Manufactured Housing sector is demonstrating resilience with valuations for manufactured housing communities trending upward.
Meanwhile, U.S. inflation has been and is expected to remain on the rise, driven by increases in fuel and food prices. Consumers are seeing their gasoline, oil, and grocery bills ratcheting up quickly as a result of pandemic-related roadblocks. Food production in this country is heavily reliant on laborers, whose working conditions made them extremely vulnerable to COVID-19. Absence of a full labor force, coupled with shifting weather patterns and extreme storms have impacted planting timelines and crop yields and in turn have hampered production, raising costs for food producers and ultimately for consumers.
Contributing to escalating food costs is the rising price of oil and gasoline. The demand for gasoline bounced back swifter than oil producers could increase production, leading to higher prices that may continue to mount as more and more Americans commute to work, take business trips, and go on vacations.
Investor optimism has increased significantly since the COVID-19 vaccine roll-out, placing the pandemic in the rear-view mirror for some stakeholders. It’s true that money is being put back to work in both the public and private markets, but with each day comes news of COVID-19 variants, so the rear-view mirror may need to be adjusted.
Although there has been a rebound in employment in this country, it is still uneven among industries. Robust stimulus measures are targeting those industries most directly impacted by COVID-19.
The imperative for investors is to remain capitalized amid the current stimulus backdrop, with goals-based planning driving investing tactics that are low-cost, tax efficient, and diversified. Assets such as stocks can grow cash flows beyond inflation, though with a high degree of volatility, while assets such as bonds often produce steady cash flows and lower volatility. Real estate assets add to a portfolio’s diversification.
The bottom line is that there exists much value in U.S. equities, infrastructure, preferred securities, and dividend growth strategies — and it makes sense to stay invested and have the right allocations. Ultimately, a well-constructed, diverse portfolio helps investors weather market landscapes and tax law changes.
The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader. For more information, visit CLAconnect.com.
CLA exists to create opportunities for our clients, our people, and our communities through our industry-focused wealth advisory, outsourcing, audit, tax, and consulting services. Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC-registered investment advisor.