Tax Trends and Considerations for Family Offices

By Xiaoyan Xiao

During the past two years multiple tax bills were enacted into law, benefiting many individual and corporate taxpayers in response to the mounting economic concerns stemming from the global pandemic. On November 19, 2021, the Build Back Better Act, which included significant tax reforms, was passed by the House of Representatives. The bill stalled at the Senate due to a lack of bipartisan support and, as of June 2022, there has been minimal discussion to revive the bill in its present form. The tax reforms proposed by the Biden administration, which could eventually get repackaged into a modified bipartisan bill, have raised concerns for many high-net-worth individuals and family offices. What will 2022 and the years to come bring? This year’s IVY Family Office Network’s 2022 Trends Forum, hosted by EisnerAmper, discussed how family offices should best prepare from a tax perspective.

Below is a recap of key highlights from the fireside chat between moderator Paul Bleeg, a partner, with EisnerAmper and Daniel Krauss, a tax director with the firm.

Strategies in Response to Tax Reform Concerns

An increase to the top marginal rate, taxing capital gains at ordinary rates and expanding the 3.8% net investment income tax to include active pass-through income are just some of the major tax proposals included in the latest iteration of the Build Back Better Act. With these potential tax changes on the horizon, accelerating the recognition of income in 2022 to lock in current tax rates may be an effective strategy. This strategy could be achieved by liquidating highly appreciated stock positions to lock in the current long-term capital gains rate, which peaks at 20%. Additionally, in a down market, owners of traditional IRAs should consider converting all or a portion of their account balances to a Roth IRA as the amount included in taxable income will be based on the fair market value of the account balance transferred as of the conversion date. Furthermore, any future appreciation after the conversion date can be withdrawn tax free by the designated beneficiary of the account.

Alternatively, a contingent of financial advisors have opted for an investment strategy that enables their clients to defer the recognition of income from a liquidity event realized in the current year by investing in qualified opportunity zone (QOZ) funds, assuming certain criteria is met. If the QOZ investment was made by December 31, 2021, investors will receive a 10% reduction in their deferred income committed to the fund that will be subject to federal income tax. Furthermore, if the QOZ investment is held for at least ten years, 100% of the appreciation from the investment can be withdrawn tax-free, which can make this an appealing strategy for investors to think about in 2022 and beyond. All investors should be aware that the income they elect to defer by investing in a QOZ fund will be subject to federal income tax for the year ended December 31, 2026. Additionally, the investor’s resident state may not conform to this federal tax regime and therefore it is recommended that they speak about the state income tax ramifications with their tax advisor.

Actions to Take on the State and Local Tax (“SALT”) Deduction Limitation

Introduced in 2017 by the Tax Cuts and Jobs Act, the SALT deduction is limited to $10,000 on federal individual income tax returns from the 2018 tax year through 2025. This has created a significant lost federal tax benefit with respect to filers that are living in high income tax states. In response to this SALT limitation, nearly half of the states with state income tax have enacted an elective pass-through entity (PTE) tax regime to help individuals recoup this lost federal tax benefit. Under the PTE tax regime, a pass-through entity (i.e., partnerships and S corporations) can make an election on behalf of their owners to pay an entity-level tax.   The PTE amount paid by an electing entity to a state may be deducted in computing its federal taxable income in the year the payment is made, thereby enabling participating owners to avoid the SALT limit on their distributive share of income. While this is a favorable outcome, the PTE rules are not consistent among the participating states, so it is critical to speak with a tax advisor to understand the state tax implications of the PTE election.

Increased Emphasis on Family Succession Planning

The TCJA made significant changes to the estate and gift tax exemption by temporarily increasing the lifetime gift tax exemption for an individual from $5.49 million to $11.18 million per person, enabling married couples to collectively transfer $22.36 million of their net worth without having to pay federal gift tax. The lifetime exemption amount per person is set to revert to $5 million effective January 1, 2026, unless measures are taken by Congress to extend the current law.   There is a growing belief among tax practitioners that the current administration might not wait until 2026 to significantly reduce the current lifetime gift tax exemption amount. As a result, it may be prudent for individuals with taxable estates that have not used their full lifetime gift tax exemption to revisit family succession planning strategies with a trust and estate expert.

Alternatively, if the taxpayer’s lifetime gift tax exemption amount has been fully utilized, there are alternative wealth transfer strategies that can potentially avoid or significantly reduce federal gift tax consequences. The creation of a grantor charitable lead annuity trust (CLAT) could create a current-year income tax deduction while simultaneously effectuating a wealth transfer to the grantor’s heirs at the end of the trust term. A CLAT is a charitable trust where the grantor designates a charitable beneficiary to receive a series of fixed annual payments, either for a term of years or over the grantor’s lifetime. The grantor will receive a charitable deduction on their individual income tax return that is based on the present value of the asset(s) contributed to the trust in the year the CLAT is created.  At the end of the trust term, the remaining assets are typically transferred to the grantor’s descendants or a trust(s) for the descendants’ benefit.

Challenges Faced by Allocating Capital into Direct Private Equity Investments:

Many family offices have begun to change their investment approach by reallocating a significant portion of their capital toward direct private equity investments with long-term growth in mind. These types of investments are close-ended and therefore restrictions are in place on the transferability of stock for a certain period that investors must adhere to. As a result, family offices that are heavily concentrated in these types of temporarily illiquid investments may face future cash flow challenges if the appropriate financial forecasting model is not in place. Therefore, it is advisable that family offices review their current financial reporting systems and invest in technology that will help enhance and streamline the reporting that is utilized for both budgeting purposes, and to make timely investment decisions. Additionally, it is critical to be aligned with financial advisors that specialize in helping their clients gain liquidity from these types of investments.

Another tax opportunity that family offices should be aware of when making direct private equity investments is the potential federal tax savings that can be realized under IRC. Sec. 1202, otherwise known as qualified small business stock (“QSBS”), if there is a future liquidity event.  If an investment meets certain criteria to qualify under the QSBS tax regime, investors can exclude up to the greater of $10 million or ten times their cost basis on the gain realized from the sale of their QSBS investment. Investors should speak with their tax advisors to determine if their investment qualifies for QSBS tax treatment and to confirm whether their resident state also offers QSBS tax benefits.