Read below for a full transcript of the conversation.
Sean Park - Welcome, everyone. My name is Sean Park. I'm a Managing Director in our Venture Capital Service Team. Thank you for dialing into our webinar today. We're excited to present the topic, "Venture Capital Tax Update: What You Should Know and How It Could Affect You." The current tax environment is complex and ever-changing. And this year it feels even more complex than ever. In today's discussion with the help of our panel, we hope to shed some light on the current environment and how it could affect you and your firms. During today's discussion, we will cover the current legislative processes, propose changes to income tax, the state tax, and charitable planning. Joining us today, we have an incredible panel of experts, specialized in various areas of tax and investment management.
With us today, we have Eric Anderson, Managing Director in Andersen's national tax practice providing state and local tax services; Lindsay Chamings, Managing Director in Andersen Tax's alternative investment fund tax practice working primarily with venture capital, cryptocurrency, private equity, hedge and fund of funds, and their related management companies and GP entities; Carl Fiore, Managing Director in Andersen Tax's national tax practice focusing on gifts, state, individual, and fiduciary tax consultants and compliance matters; Heather Harman, Managing Director at Andersen Tax's national tax practice, and previously served as legislative tax accountant for the US Joint Committee on Taxation; and last but not least, we have Danny Lee, who's a Senior Managing Director and Wealth Advisor in First Republic's private wealth management division. If I could take a minute for each of the panelists to introduce themselves, that'd be great. Eric, why don't we start with you?
Eric Anderson - Great, thank you Sean. I appreciate it. My name is Eric Anderson, as Sean said. I've been fighting with the state of California and other states around the country for about three decades now, having been a reformed attorney coming out of the Pacific Northwest and then moving to California a couple of decades ago. And really looking forward to partnering with First Republic on this presentation to talk about what's going on in the world of state and local tax.
Sean Park - Great, thanks Eric. Lindsay?
Lindsay Chamings - Hey everyone, I'm Lindsay Chamings, and I am a Managing Director in our firm's alternative investment practice. So a lot of my clients are venture funds. And I think a lot of the topics, we tried to curate them pretty well to hopefully what the user group is on this webcast. So thanks for tuning in everyone.
Sean Park - Great, thanks Lindsay. Carl, if you'd like to go next?
Carl Fiore - Thanks Sean, hi everyone. I'm Carl Fiore, I'm a Managing Director in our US national tax group although I sit in New York. And today I'm actually literally sitting in New York instead of my basement. So I spend most of my time helping the other partners in our firm with issues relating to their high net worth individual clients and families, income, charitable planning, trusts, and estates structuring. You know, if I had to say it in five seconds, I'm kind of like the firm trust and state's attorney.
Sean Park - Great, thanks Carl. And Heather?
Heather Harman - Hi everyone, I'm Heather Harman. I'm a Managing Director in Andersen's national tax office as well. And unlike Carl, I do actually sit and live in Washington DC on Capitol Hill. As part of my role in Andersen, I focus a lot on domestic business tax issues. But also, as Sean noted, before joining the firm, I spent three years as a staff tax accountant for the Joint Committee on Taxation of the US Congress, where I worked with both the House and the Senate and Democrats and Republicans on any and all tax policy issues including the crafting and enactments of the tax cuts in the Jobs Act. So as a result, I also kind of sit on Andersen's internally our tax policy team that monitors what's going on on the Hill and advises clients accordingly.
Sean Park - Great, thanks Heather. And, last but not least, Danny?
Daniel Lee- Sure, hi everyone. I'm a Senior Managing Director in First Republic's private wealth management practice. I came from the family office world and really advise family offices, GPs, and entrepreneurs on things like balance sheet efficiency, state tax mitigation strategy, productivity of capital and in endowment-like investment management. I'm also one of eight people at the company on our investment committee.
Sean Park - Great, thanks Danny. All right, so before we start, just a quick housekeeping note. We welcome questions. If you can ask your questions in the Q&A, we'll try and get to them at the end. We hope to have 10 minutes or so at the end to answer your Q&A. And if we don't, we'll follow up by email. All right, let's get started. The first question I have and it's for you, Heather. In November, Congress passed the 1.2 trillion Infrastructure Bill. We still have a lot of work to do with the Build Back Better bill. Can you give us the latest update on that, where things stand and what needs to happen?
Heather Harman - Sure so currently, the Build Back Better Act was voted on and passed the House prior to Thanksgiving. And up until, I would say, early November, I would have expected that once the House took its vote on the Build Back Better package, that we would quickly see a quick vote in the Senate, followed by enactment and signed into law by President Biden. And that was because up until early November, the House and the Senate were working on pre-negotiating agreed upon package to make the bill so that before the House took its votes, they would have already kind of pre-negotiated and reached agreement with the Senate as to all the finer details of the legislative package. As we saw in early November, those negotiations did ultimately fall apart a little bit there at the end, which means, so the House has voted and sent the bill over to the Senate, but we know the Senate doesn't 100% agree with what's in there right now. I think that's gonna start extending out the legislative process for this bill because, before it can go to the floor of the Senate for a vote, first it needs to serve some time, which is what it's doing right now, with the Senate Parliamentarian, so she can do a detailed review of the entire legislative package to make sure that everything is in agreement and allowed under the Senate budget resolution procedures.
But then also, the Senate's going to be making its own amendments to the bill to bring it into an agreed upon package that will have 50 votes in the Senate. So I think those two items combined means that we're probably not going to see movement in the Senate this week. I've recently heard that the Senate Parliamentarian's review is expected to last until sometime next week. So that's like the second or third week of December. Sometimes the members do like to work all the way through the very end of the year on December 31st, but they do also like to be with their families for the holidays just like the rest of us. As a result, I think we've seen recently, there's been at least two or three members who've said in the press that they think the likely timing for this potentially to be enacted into law might actually roll over into early 2022. Certainly not the speedy process that a lot of us were expecting at the start of 2021 when President Biden assumed office and Democrats took over control of both the House and the Senate.
Sean Park - All right, from a revenue standpoint, what key provisions are still being negotiated? And there's a few follow ups here, but how real are these prospects of change? And could you handicap them for us?
Heather Harman - So in the tax policy space, the one open item that we know of publicly are the continuing negotiations over how to modify the cap on state and local taxes for individuals. As we saw back in November on the same day that the House announced that it had finally found a compromise proposal that had support in the House, the Senate the same day announced a counter proposal to make different modifications to the SALT cap. So I think, one, we know the Senate's likely to be modifying the bill to match what the senators want to do but it's also going to be a key difference between the House and the Senate that's going to need to be worked out before anything could be enacted or signed into law.
Sean Park- All right, so with these developments, what are you guys focusing on from a client perspective, income tax, gains tax, charitable issues?
Heather Harman - I think in our key focus overall throughout 2021 for advising clients, I think we have clients looking at planning and across the board in all the areas that you've mentioned, but I think the focus has been on making sure that you're implementing tax planning that makes sense in either case. Whether the bill becomes law or whether it'll all just falls apart and nothing actually comes to pass, making sure what you're doing is not something you're going to regret a few months down the road. So making sure that we're not entering into transactions or structures that can't be easily unwound, if the law ultimately don't change. All right so, for example, back when a direct increase in the capital gains rate was still in play for most of 2021, we still would have talked to a lot of clients who are already planning transactions where they knew they were going to have some capital gains in the very near term, working to accelerate those transactions and closing those agreements to get those capital gains in before we thought the rate might go up. Now, obviously with that, with a direct increase off the table, I think a lot of clients who didn't rush to trigger capital gains 'cause they were normally planning on making a sale until you have 5, 10 years down the road are feeling pretty good about not rushing into that process because, as we've learned, things can quickly change when Congress is negotiating a package of this size.
Sean Park - All right. I've got a question for you, Lindsay. From a Carried Interest Regulation perspective, what is proposed, what is likely to pass, if you could suggest, and how will it affect GPs and other partners receiving carried interest?
Lindsay Chamings - So kind of a huge sigh of relief here. As you know, everything changed back in 2017 with the tax cuts and Jobs Act when they enacted 1061, which changed the holding period for GPs. If you want to get long-term tax rates, you have to hold the underlying asset for three years. So in some of the earlier versions that we had seen developed, there was talk of changing that to five years. And luckily, that did not make its way into the current version of the Build Back Better Act. So, yay, I guess is great. It doesn't mean that it won't come back to rear its head again. I don't think we can say we're completely out of the woodwork because it affects a smaller group of individuals in terms of the population. It is something that could change again. But because we still are under the current rules with what came out of the tax cuts and Jobs Act, we got final regulations at the beginning of this year. A lot of our questions are finally being answered here. And what we see because of that is people are sticking with the strategies that they've developed over the last couple of years. We're telling all of our clients to do a really good job of keeping records that track the carry allocation versus the capital allocation that you have, allow for flexibility in your agreements to distribute securities if you're not going to meet the holding periods. And then more nuanced, you know, think about updating agreements for flexibility to have, not fee waivers, carry waivers, very similar to the fee waiver concept, but to forego potentially carry that you've earned in early years of the life of your fund for an additional carry later on when potentially the underlying assets have been held beyond the three-year holding period. Obviously, there should be a lot of details spent on making sure that you draft those provisions correctly. But giving yourself some flexibility to be fluid around those things, I think is going to be really helpful long-term.
Sean Park - So it sounds like just given where we're at, a lot of advice is, be flexible right now. We don't have any clear guidance one way or the other as far as. All right, great. The Build Back Better framework calls for tax surcharges at the 10 million and 25 million levels of Modified Adjusted Gross Income, the ordinary income tax brackets applied to taxable income. What's the difference between Modified Adjusted Gross Income and taxable income? And why is this definition so important to GPs?
Heather Harman - So there's some big differences between Modified Adjusted Gross Income and taxable income. So Modified Adjusted Gross Income is basically just what we define as adjusted gross income reduced by any investment interest expense deduction. This is an income number that's before your charitable deductions, before other itemized deductions and before things like your 199 cap A, deduction for pass-through business income. Also, because it's an adjusted gross income number, character doesn't matter. It's going to apply to any ordinary income you have that year, but it's also going to apply to any capital gains recognized in that year. So that's, I think, a really important distinction between the two terms is, once you've triggered and recognized a capital gain, there's really no way to plan out on not having the surtax apply. Previously, someone's changing the character of an item can change tax treatments. I think this is one where ordinary versus capital is going to be less of a distinction because ultimately, once it hits your adjusted gross income for a taxable year, it's going to be subject to the surtax. And then, I don't know, Lindsay, if you could speak to any more detailed planning that you've used in your clients, you're thinking about so far when it comes to the surtax.
Lindsay Chamings - What's tricky there is you're weighing a lot of different people when you're looking at a fund structure. So potentially we have a lot of clarity on whether or not the GPs might be in the surtax position, but we don't necessarily know for all the LPs. Thinking about whether or not installment sales makes sense in the context of these is something that people can do.
Sean Park - Great. This one I think would be for you, Lindsay. Qualified small business stock is part of the conversation in Washington. It's been part of the conversation, I think, for many years now, but, it's back in play again. Can you give us a quick update on where we're at today with those changes?
Lindsay Chamings - Yeah, and so this for early-stage venture groups is a huge windfall, right? Because just kind of quick summary nutshell, you can exclude from taxable income if something qualifies as qualified small business stock. The gains on that stock, you can exclude from taxable income the greater of 10 times your basis, or $10 million, and that's on a per security per taxpayer basis. If it's a lot of your portfolios, startup, is in the US originally issued stock, the adjusted basis of the assets is $50 million or less. That's great for everybody. Even some states conform, obviously California does not, but the current version of the Build Back Better Act is putting in place limitations of this. It is saying that only for those high-income taxpayers defined as earning over $400,000 filing single or 500,000 married file jointly, as well as for all trusts and estates, they're now putting into place a 50% limitation on that exclusion. We kind of go back to what we had before the Obama era lifted those exclusions. If you're no longer paying tax on half of that gain, first of all, you're going to be paying a 28% tax rate on those gains.
You're going to pay your net investment income tax on those gains. And in addition to that, you're going to have a 7% AMT add back, which most of these taxpayers end up being in. It's whittled away at the benefit. It's still there. Your effective rate is still going to be better than your effective rate for long-term capital gains. It's still a benefit, not as powerful as it used to be though. An interesting nuance I think about this provision is that it goes into effect for realized transactions that occur on or after September 13th, 2021. It's retroactive. And it's based on the date of realization, which is what we saw when they enacted 1061. But when they previously lifted the limitations on QSBS, they did it based on the date the stock was acquired. This is a bit of a deviation from what they've done in the past related to qualified small business stock. So, is that possibly room for change? It's very possible. I didn't think there was going to be changes on this. Just, you know, the marketing of this is really good, qualified small business stock. And when they lifted the previous limitations to give you 100% exclusion, that was all under the Obama administration. I didn't expect this to be on the chopping block, but it is in the current version of the bill.
Sean Park - Yeah, this has been a great provision. I hope we can still at least benefit from the 50% exclusion, we'll see. Okay so, this is a long-winded question for you, Lindsay, so bear with me. Changing the definition of net investment income to include income from active trade or business has also been part of the conversation in DC. What is considered net investment income? How does net investment income factor into the 3.8% Medicare surtax that was enacted under the Affordable Care Act? And what impact and change would this have on GPs? There's a lot there, sorry.
Lindsay Chamings - It is a lot, that's all right. I'll hopefully answer them or say something that makes sense. That's my number one goal. The net investment income tax is generally a tax that's assessed on investment income. You are applying that 3.8% tax to your capital gains, your interest, your dividends, right? So now they're saying again for these same thresholds that we just mentioned related to qualified small business stock, that you'll also have to pay this net investment income tax on active trade or business income from the taxpayers. This is not going to be assessed on that type of income that's already subject to FICA self-employment tax, but it's ensuring that now that owners of these pass-through entities are either going to be hit with the 3.8% tax related to net investment income tax, or they're going to be hit with 3.8% tax as it relates to self-employment FICA tax. Now, not as prevalent in the venture space. We definitely see it more often in fun setups where they're trading in public equities, but we see it more often in venture funds as well. There was a lot of structuring that was done to try to mitigate self-employment taxes. And now, since you won't be able to eliminate self-employment tax, because you'll be subject to the new net investment income tax on that income, it may make sense to revisit that structure. Because when you pay the self-employment tax, you end up getting a deduction for about half of it. So, in a way, it's a better position to be paying the self-employment tax on that income versus the new net investment income surtax. So people should review their structures and see if there's any way that they can potentially mitigate this change.
Sean Park - Great, write that one down. Okay. This one's for you again, Lindsay, this one's easier. What can my management company and GPN fees do to decrease GPs' individual tax burden in 2021? I suspect I know the answer to this one, but go ahead.
Lindsay Chamings - Well, I don't know about necessarily in decreasing the tax burden per se, right? So when we thought the rates were going to go up, everyone was in this mood to bring income into the current year, push expenses out, which is the inverse of how we're usually thinking about taxes. We're always trying to defer taxes. We're always pushing the income into the next thing. So people wanna kind of flip around what they were thinking about a couple of months ago to make sure it still makes sense with the goals of their company, with their cash planning needs. The other thing I think people should really be paying attention to as we get into this next year is, the tax returns are going to look different for your investors and for yourselves. There's a K2 and a K3. It's going to make everything longer, it's going to make the reporting harder. So be ready for that in terms of what it takes and what you're promising to your investors in terms of timing. With various remote workforce, so wherever your people are operating, there was a lot of leeway during COVID about some of these things, and there's a lot less leeway now.
Think about where you have state issues, think about how you're sourcing the management fees and what impact that has. Like I said with the net investment income tax, make sure that you've thought through your structure on that. You also want to make sure that your agreements have flexibility related to carry like we talked about previously, but also have flexibility related to the allocation of certain items, as various states implement pass-through entity taxes. We haven't really touched on that yet, which is why we have Eric here because he is the head of our firm's state and local tax practice. He can do a deeper dive into that. But giving yourself flexibility to adapt to those changes so you can get the state benefit for whether it's your investors or the GPs themselves, thinking about where you can take advantage of that planning.
Sean Park - Great, thanks Lindsay. Well, let's switch it over to Eric now. Changes to the current SALT limitations have been discussed in DC. Can you give us an update on what's being proposed, what's likely to be passed, and if passed, how will it affect the individuals and families?
Eric Anderson - Yeah sure, happy to. It's interesting, Heather talked a little bit about the SALT limitation, but I love the question of, well, what do we think is likely to be passed? I have my Jedi sword back here, my lightsaber, and I'd love to be able to say, these are not the questions you want to be asking me and give you a Jedi mind trick because we really have such a jumbled mess of what's happening in Washington right now. The SALT deduction currently stands at a $10,000 limitation on state and local taxes being deducted in your personal income tax return. And that is going to sunset in 2025. That was done with intention with the TCJA to minimize the number of people that are itemizing their deductions and decrease the number of more complex tax filings that were coming in. But it was also done as a pretty significant revenue raiser. The blue states have quite a complaint about that, which are where more of the higher taxes, income tax burdens, were being shouldered. A group of principally the blue state proponents of getting rid of the SALT cap limitation have come together and threatened not to pass anything, including some of the House members of New Jersey in New York, unless there is some kind of tinkering and relief on the SALT cap deduction.
What has recently been passed is an increase of that limitation to $80,000 up through the year 2031. And then we would revert back to the 10,000, and then the cap may go away altogether. So that would give some relief. Now the Republicans have been put in this interesting position of challenging the Democrats on this bill and saying, well, really using the BBB alliteration, this is really a blue state billionaire bailout, which Senator Grassley from Heather's home state of Iowa, has talked about in terms of this being a giveaway to the wealthiest 1%. And in fact, the highest 20% of taxpayers would actually bear the biggest benefit out of this, people making over $175,000 a year. Now, do we think something will pass? We think so. But it is not fully baked into the plan yet. So as of right now, we're looking at an increase to $80,000 and that is the most likely proposal to pass. But will it pass? We actually don't know.
Sean Park - Thanks, Eric. Many states are passing legislation to help partners in partnerships to get around the current SALT limits. How do these new laws work and how can a GP benefit?
Eric Anderson - You know, I'd love to have a dollar for every hour I've spent on the brain damage of trying to figure out all the pass-through entity taxes. At last count, there are about 26 states that have these regimes. It started on the East Coast with Connecticut, and then it spread across the country, including California passing AB 50 this last year and other states jumping on the bandwagon like Arizona pretty recently as well. What this is, is if you have a flow-through entity, whether it be a partnership, an S-corporation, a limited liability company treated as a flow-through, that ultimately flows through to a taxpayer up the chain and usually an individual, that the entity can elect to pay the state taxes on behalf of the individual. So what does that do? Well, what that does is it shifts the tax deduction to the entity so that the income that is flowing through the entity to the individual partner is deducted before you take into your federal taxable income your tax base. So, for example, California is a 9.3% tax, it can be paid at the entity level. If you are a partner in a partnership and you have a million dollars of taxable income that is going to flow through that partnership to you, the partnership can pay the tax on your behalf, which would be $93,000 on that million dollars.
On an individual level, you would get a $93,000 tax credit against your California taxes. Which means you have $93,000 of tax related to that income, you get a $93,000 tax credit. Your net is nothing in California, there's no impact, because the entity has paid the tax on your behalf. However, when you take your income into account from the entity for federal tax purposes, you have a $93,000 deduction. So now your income is not $1 million, it's 907,000 that is going to be flowing through from the entity. If you take $93,000 multiply it by the federal tax rate, let's call it 40.8% short-term capital gain, subject to ordinary rates, with the Obamacare tax on top of it, you have about a $37,000 benefit on the pass-through entity taking the deduction on your behalf and paying that on your behalf. Now there were some issues with these. Not all of them are constructed the same in California. Somebody can opt in, whereas as somebody else cannot opt in. Other states require all the partners to be subject to the pass-through entity taxes. There are some issues with residents and non-residents where, if you're a non-resident taxpayer in a state because you have income source to that state, you may or may not get a tax credit for the taxes that are paid by the pass-through entity in that state. You have to watch out for some of these weird nuances. In California, you could run into the alternative minimum tax. The credit that is flowed through from the flow-through entity only reduces tax down for your regular tax burden, but not your alternative minimum tax burden. You need to do some modeling to see how that pans out at the individual level. And then you also want to watch your payment date. The payment is deductible by the flow-through entity on the day that it is made and in the year that it is made. If you want your deduction for 2021, the entity needs to pay the tax at the entity level in 2021. We have, yeah, a few days left for you to do that.
Sean Park - Wow! It sounds like a lot of our CFOs are going to have fun with their tax preparers going forward.
Eric Anderson - They will, and Sean, you know, we're getting questions on this. Jason had asked a question in the chat about AB 150 in California, and there is this nuance around how this works for certain entity structures. And there's some odd complexities here where if you have an individual owner of an entity, that is not a flow-through entity under the way that this law is constructed. It has to be an entity that is treated as a partnership for federal income tax purposes or an S-corporation. A single member entity does not qualify. Now if you have a single member entity that is in turn a partner in a partnership, then you have another issue. Which is, if that single entity is a limited liability company, then the owner of the single member limited liability company, which in turn is a partner in a partnership, is not qualified merely because of the existence of the LLC. And that's a nuance in the California law that needs to be worked through. If anybody has those types of structuring situations, there are ways that we may be able to structure prospectively to get you into the benefit. But there are some limitations that are very particular under the California law.
Sean Park - Sounds super complicated. I think we're going to have to call your team, Eric. But okay, great. Let's see, across all industries, we see individuals and family moving states to decrease their state tax burdens. For any GPs considering moving for tax purposes, what would you have them keep in mind, Eric?
Eric Anderson - So as of this morning, we're helping about 113 people move out of the state of California. I should have a sign behind me that says, "Andersen moving company," because we're helping so many people move out of the state. I think we're seeing the same thing in New York with our New York practice and across some of the other higher tax states. Some things to keep in mind. I don't think taxes are going to be going down in some of the higher tax states. It seems like California and New York City keep having an arms race where it was 9.3, then 10.3, then 11.3. Then New York City kind of caught up. Now New York City is actually higher than California's 13.3% rate topping out at a little over 14. We're seeing quite a few people considering leaving their home state. A couple of things to think about are exit events. You can leave a state and go to another state, establish residency in another state before you have some kind of large income event. But you need to be careful and you need to do it right. You need to understand the rules of residency and when that change actually takes effect. I think of the East Coast and the West Coast as having two different approaches. East Coast, there are statutory residency provisions. If you are in New York for 183 days, and you own a principal place of abode that is suitable for habitation year-round, even if you're never in it, you are treated as a tax resident of New York.
That is not the rule in California. The rule in California is, where are you a domiciliary? Where do you have your closest connection? Which has a component of time and an element of just kind of the soft things, of where do you really live? Where is your family, where are your friends? Where is your locus of activity? And where do you stay with a permanent intention to be there? The rules are a little bit more facts and circumstances based. What I would say for anybody contemplating moving is prepare. We know what is going to happen in a tax audit. We gather all of the documentation and facts available to us now, so that when you get an audit three, four or five years from now on a move that happened in 2021, that you have the documents ready to prove that you actually did in fact move. And then watch out for sourced income. Before you move, everything is taxable in the state of residence. After you move, if you move to a state that is a no tax state like Nevada or Florida, Texas or Wyoming, Tennessee, all of these places that our clients are going to, then at that point after the move, you are taxed only on your sourced income to the state, which would not be interest, dividends, capital gains; it would be anything that could be pulled back to that higher tax state. Work that is performed there, properties that are left there, income from a business that is conducted there.
Sean park - Okay, thanks Eric. Let's switch over now to some of these estate tax issues. And I have a question for you, Carl. For quite a while, some of the changes being discussed in Washington were directed at planning techniques that serve as estate planning building blocks, such as grantor trusts. None of those proposals are in the current proposed legislation. What conversations are you having with clients now that the original changes that were being discussed and proposed are no longer part of the current version of Build Back Better?
Carol Fiore - Yeah, so it's been a really interesting last three or four months. We've kind of been doing planning via extra sketch, where five months ago we said, okay, we have to consider what to do because they're going to get rid of the basis step up and say, okay, no, no, no, that's not in there anymore. Then it was grantor trust, what are we going to do? Okay, that's not in there anymore either. And now we have, you know, with respect to the Build Back Better bill, and specific to trust, we have the surcharge, right? What are some of the things that we're focusing on now? The same things that we were focusing on five months ago that we said are still really good planning techniques. Things like grants, things like installment sales, where you still have two really good factors economically with respect to those types of planning techniques. One, very low interest rates, right? What determines the interest rate on a GRAT is what's called the 7520 rate. Back in 2008, the 7520 rate, after the financial collapse, the 7520 rate along with the other interest rates completely bottomed out. And they never really got back to where they were before. And then, you know, then COVID hit, they bottomed out again. And they're creeping back up, but we're still at historic lows.
And any sort of planning technique that is interest rate driven, such as a GRAT or a charitable lead annuity trust or an installment sale, those all still make a lot of sense now because interest rates are still so low. And the other thing that's happening is, despite all the uncertainty that there is out there, the market still seemed to be going up. So when you have a very low interest rate environment and an appreciating asset environment, those types of planning techniques that really, you know, what they involve is passing appreciation onto the next generation, those are still really, really good techniques. And so we had to pump the brakes a little bit on those when we thought that some of the grantor provisions were going to be, you know, in the legislation. Now that it looks like they're not, it's game on again. The other thing that we've been focusing on, again, what is now in the Build Back Better bill? And that's the surcharge, right? And so, as Heather was talking about the surcharge and Modified Adjusted Gross Income, we looked at individuals. And for individuals, you're at the full boat, 8% of 25 million. For a trust, and I'm talking about a non-grantor trust now, a trust that pays its own tax, you're at 5%, at 200,000 of income, and the total 8% at 500,000 of income. You only need something like $10 million in a trust before you're probably hitting 500,000 of taxable income every single year, right? So that is significant for trusts.
And so some of the things that we've been looking at, specific with trust is, can we shift income away from the trust and to an individual? And generally with a trust, from the individual perspective, there's a grantor and there's beneficiaries, right? So when we were concerned about grantor trust, we looked at our trust and said, are there trusts that we should be converting to non-grantor to potentially avoid some of the bad things that could happen under these provisions? Now, we want to do exactly the opposite. Now we want to look at our trust and say, hey, if we have an individual whose income is about 5 million a year, which is still a pretty high amount of income, but the trust would easily have $500,000 a year, if we can shift that 500,000 of income to the individual, because we've now made that trust a grantor trust, the individual is still nowhere near paying the surcharge. And now, the trust is a grantor trust, there is no surcharge there. The other individuals generally associated with the trust are the beneficiaries, right? Most people are with non-grantor trust and the 65-Day Rule, where at the end of the year, you might look at a trust and say, okay, we have taxable income in this trust, we have beneficiaries that pay tax at a lower rate, why don't we distribute some taxable income out to them? And under current rules, yeah, there was usually some tax benefit to this because, again, the trust get to the highest marginal rate, it's something like 13,000. And individuals get there, it's something like 400,000. But it was a marginal benefit.
Now with the surcharge, this could be a lot more than a marginal benefit, right? And one of the things that will reduce a trust, Modified Adjusted Income, is a distribution now, the income distribution deduction. That brings us to a practical issue. Now we have something that may be great sense from a tax perspective, but what we would be doing is putting lots of cash in the hands of beneficiaries. Well, one of the reasons why we have trust in the first place is to prevent beneficiaries from getting their hands on cash. And so what can we do there? One of the things that we can do there, and we actually had a conversation last week with a client about this, is if instead of distributing out cash, if the trust sets up a partnership and puts its cash into that partnership, the trust then distributes out the partnership units. Same impact from an income tax deduction, still lower the trust adjusted gross income, but now what the beneficiary has isn't cash anymore. Now they have a limited partnership interests that they really can't do anything with. And so for all the non-tax reasons that we like to use trust, that partnership will now do the same thing, essentially protect the assets from some of the bad things that are lurking at out there.
Sean Park- That sounds great. I want to pull it back to QSBS a little bit too. It's very near and dear to my heart, especially coming from venture funds. But are there any strategies for gifting QSBS or carried interest, and what should we keep in mind in that account?
Carol Fiore - Yes so, planning with QSBS and planning with carried interest, those we tend to keep separate because the planning is oftentimes different if you're simply focused on QSBS or simply focused on the carry. With respect to QSBS, as Lindsay mentioned, under the Build Back Better provisions, the QSBS benefit is slated to be cut in half, right? But you're still getting half of the benefit. And at, you know, 5 million versus 10, that's still significant, right? And so I think we're doing the same things that we were doing before the specter of Build Back Better came out with trust. And that means creating QSBS multipliers. Creating non-grantor trusts that are separate tax paying entities that could sell QSBS and get their own exemption, right? And there are certain ways that you can and cannot do this, or there are certain rules that prevent someone from setting up, you know, 100,000 trusts and putting in all these QSBS stock in order to generate additional multipliers, right? And so, you know, this has to be done smartly and being mindful of what the IRS is trying to prevent. But there are still a number of ways to use trusts to create multiple taxpayers for QSBS purposes. On the carried interest side, depending on some of the income tax considerations, generally speaking, you're still using grantor trusts.
The issue usually with carried interests are not so much the trust, but the actual transfer of the carry. And here's where we get into the whole vertical slice thing and having to give a proportionate interest of carry and limited partner capital interest in a fund. Depending on how much control a GP might have, there are ways that you could avoid that. And the reason why you'd want to avoid that is because when you start up a new fund, the carry has next to no value, but that's where all the growth potential is. You know, the new fund, the value is vested in the capital interest but it doesn't have the same growth potential that the carry does. So naturally the carry is a better asset to give for gift tax purposes, but you just have to be wary of, and I promise I won't do this again or I probably won't do this again, but I'm going to throw a tax section out there and it is section 2701. Some of you may be familiar with this, and how you have to go about giving your carry in order to not run afoul of what can be a nasty and difficult section to deal with. The other thing to keep in mind, Eric was talking about people changing their residency for state income tax purposes. Well, sometimes the individual might not be able to change their residency, but a trust can, right? So in California, you know, particularly with QSBS in California, because California doesn't recognize QSBS, there are ways to be able to use trusts to either defer or eliminate state income tax. We've been doing a lot of that. And the more aggressive states have gotten, the higher the rates go, particularly in my state New York, and a lot of your state, California, the more focus there is on that type of planning.
Sean Park - Great. There's another one for you, Carl. Forgive me, this is another long question so bear with me. The provisions to lower the state and gift tax exemptions from 11.7 million to 6.02 million are off the table. Do you think that it's important that GPs still take full advantage of the lifetime gifting exemption? Or do you think a wait and see approach may be more beneficial? Can you give examples of situations where one approach might be more appropriate over the other and what are you telling your clients?
Carl Fiore - Yeah, so I think in most cases, the answer is absolutely yes, use your exemption. And, you know, part of this is practical and part of this is numbers-based. On the practical side, I always have said that one of the most difficult parts about trust and estate planning is that people don't have to do it, right? You have to file an income tax return. If you get audited, you have to address that. You don't have to do this type of planning. And because it involves contemplation of death and dealing with some issues that people often don't want to talk about, this is an easy thing to defer, all right? And so one of the benefits from the tax legislation that said, oh, the exemption is going down at the end of the year, this motivated people to say, okay, I better start doing this stuff. My advice to those people is keep going. Let's finish what we started doing. One, the exemption under current law is still slated to go down at the end of 2025. And let's not find ourself in a position that we're scrambling in October, November, and December of 2025 to do what we started doing in October, November and December of 2021, right?
The other thing, and this is completely legislative-neutral, if people kind of wait and say, well, let's see what happens, what's happening while they're waiting? The value of their estates are going up. Particularly amongst the wealthier. The name of the game is getting growth out of the estate. And the faster you can use exemption, the more wealth you're going to get out of your estate, maybe not today, but 20, 30, 40 years from now when you die and when the estate tax would be applied. The caveat that I would give to that is for people who entered into what most practitioners would call risky transactions only because they wanted to use all their exemption before the end of the year. And what I mean by that is, for a variety of different reasons, there is a segment of client where they weren't comfortable giving all of their exemption without having access to it. And so then you started to see transactions like gifts of a promise to pay, or the grantor being included as a beneficiary or some more complicated esoteric transactions involving partnerships, where technically you're using your exemption, but you haven't really given up economically any of the property, right? Those are the types of transactions where, now that there is additional time, we might say, all right, let's stop for a second and rethink this. Now that we have the extra time, can we do something that's maybe a little less risky and avail ourselves of this time? The other thing that is not in this new legislation is the elimination of family discounts. People were rushing to set up family partnerships and make discounted gifts. Well if you're familiar with where IRS has been successful in attacking family entities, it's been the fact pattern of, taxpayer rush to put almost all of their assets in a partnership and started doling out gifts. That's where you have to be careful, where IRS could have some success. Now we'd say, all right, let's re-examine what you put in the family partnership, does it make sense to keep those assets in there? And now let's come up with a more thoughtful gifting program with those interests so we don't run into those bad fact patterns.
Sean Park - Alright so, what benefits would GPs receive by making charitable gifts before the end of 2021 that may not exist after 2021? Is there anything in the current proposal that might impact charitable giving? I suspect this might be the same sort of answer before, but I'll throw that one at you, Carl.
Carl Fiore - Yeah, so the biggest issue with charitable planning going forward for individuals is the surcharge. Because, as Heather said, the surcharge, the Modified Adjusted Income, does not include deductions like charity. In theory, you could have someone that gives away all of their taxable income, has virtually no taxable income, so pays virtually no ordinary income tax, but still has a big surcharge because charitable deductions aren't taken into account for purposes of the surcharge. So from that perspective, yeah, it's probably a good idea if you're going to make a big charitable contribution, maybe do it now, if you think your income is such that you would be subject to the surcharge. The other thing to take into account, I said before that the rules for trusts' Modified Adjusted Gross Income, are different than individuals. Well, one of the things that, I mean, literally at the last minute, before the Build Back Better bill got out of the House, was someone threw in that charitable deductions for trust are considered part of Modified Gross Income. A trust for the surcharge purposes can get a deduction for charitable planning. What you might see are contributions of assets to a trust that don't necessarily have anything to do with the gift tax and don't necessarily use gift tax exemption, but will allow for the trust to make charitable contributions instead of the individual, and so there's a tax benefit for surcharge purposes, as well as ordinary income purposes with respect to the deduction.
Sean Park - Alright, well, I'm trying to be mindful of the time now, I know we're running short here. I'm going to fast-forward a little bit here, and I'm going to direct the question here to Heather. Having worked with clients through various tax law changes in the past decade, what, if anything, is different this year?
Heather Harman - I think the biggest difference in this current environment is just the uncertainty. I mean, one, we've just got uncertainty as to, you know, whether and when we ultimately see something enacted, but in the tax policy space, it's kind of a little bit shocking and surprising that we're this far into the process and we still have some uncertainty as to which tax law changes are going to make it across the finish line. I think a big driver of that is because this isn't really a tax bill as we're used to kind of thinking about them. Build Back Better Act is a spending bill, right? And so, as we've kind of already seen as the spending levels have come down, we've seen a lot of tinkering and changes on the tax policy side. I think that's really the biggest difference. I think it's what's driving the biggest challenges for our clients and taxpayers. 'Cause they're trying to plan towards what's still, unfortunately, a moving target.
Sean Park - Makes sense. So, Danny, I'm going to turn it over to you now. Given everything we've heard today, what advice are you giving clients? What are some of the best practices that you're advising clients to do?
Daniel Lee - Yeah, it's a great question. I think we got a lot of information here and I agree there's a little bit of uncertainty, so let's take, you know, the knowledge we have and the laws that we have now, and let's use those to a plan. I agree with Carl, there's a time value of money argument that making gifts sooner than later is net creative to the balance sheet, particularly with our clients where catalysts to continue to wealth creation happen very quickly. If I'm a GP and we're starting a new fund, that carries value to zero, right? I can pass on more using less of my exemption. The estate tax is always going to be around. It's been around 99 out of the last 100 years. The one year there was a holiday, 2010, coincidentally when George Steinbrenner died, was able to pass the Yankees off to his heirs. Someone should investigate that. It's here. We have the largest exemption that we've had. So yes, I think it would behoove us to look at that. Now, what are some of the things that our clients contend with is, number one, how do we model the point in which the utility of the dollar on the balance sheet is diminishing for clients? And not only that, becomes unproductive to grow the balance sheet, right? In other words, how much money do you need under very conservative assumptions to satisfy your lifestyle? Because we never want to get in a situation where we're gifting more than we need under, like I said, really conservative assumptions.
We do a lot of work to get to that point. I think we also contend with some of the unintended consequences of estate planning, which are oftentimes, okay, we're giving away $23 million in today's value. If I have young children, what are the implications and protection mechanisms, when they come of age, gifting away $100 million dollars, right? I think that's less talked about. And in fact, there's about 40 years of academic research around best practices, you know, effectively, and this is crass, how not to mess your children up. I think that is equally important to the numbers, right? And to being diametrically opposed to taxes. As a matter of practicality, these are families. And we spend a lot of time, yes, getting the model right. Making thoughtful recommendations on amounts and what assets to move out and why. But again, I think importantly is, let's review the merits to each strategy and, again, a lot of the downsides. Because it's a lot to think about. These are permanent gifts. It's very difficult to know what's going to happen 30 years from now. And so, let's really do the work on an individual basis.
Sean Park - Great, thanks Danny. All right, I think we have three minutes for Q&A so I'm going to switch it over to my colleague Caroline Hale. If you can maybe address some of those questions, Caroline, that'd be great.
Caroline Hale- All right, I've heard that the Build Back Better bill includes a prohibition on putting investments for which you must be an accredited investor IRAs. And the language goes back to September 13th. How likely is this to stay in or has it already changed?
Heather Harman - This is Heather, I'll take that one. I believe that provision has been dropped out of the most recent version of the Build Back Better Act. As to whether it could make a reappearance, my gut is that at this point, it is no. I mean, I think as I've kind of already noted, we've seen the spending side of this bill trend downwards since the beginning of the negotiations. And this isn't a tax bill, right? They're only trying to raise enough revenue to pay for what they're spending on the other side of the balance sheet. And so unless spending goes back up, we don't need to raise any more revenue. And so I think we're unlikely to see things make their way back in, unless they're coming back in as a replacement for something else that's been dropped, they're going to keep the revenue side of balance.
Caroline Hale - Great, thank you. For Lindsay, what types of fun structures are avoiding the 3.8% and IIT on carried interest in 2021?
Lindsay Chamings - It's not that carried interest that's being avoided. The play was to avoid self-employment taxes in the management company structure. It's pretty hotly contested. A couple of years ago, it was an issue that the IRS was auditing although there are a lot of cases still outstanding on it. But by structuring your management company as an LP, you can take a position that a portion of the earnings are not subject to self-employment taxes. But if this law passes, then they will be subject to that net investment income tax. Whereas the self-employment tax is usually a better answer because you get a deduction for half of it. But I can talk to you offline and go into more details about how that works. Not without risk, but definitely something that's done a lot.
Caroline Hale - Great. Looks like we better wrap up. So, I'd like to thank our speakers for a terrific discussion and sharing your insights during this informative session. Thank you to all the GPs, finance professionals, and founders who joined our discussion today. We appreciate your interest on this topic. These are very important issues requiring careful consideration. As follow up to any questions you may have, we encourage you to speak with your accountant, attorney or other advisors before taking any action to ensure you fully understand how changes may affect you and the plans you have put in place. At First Republic, we're proud to serve you as part of the innovation community across the US. Please feel free to reach out to any of us for any of your financial needs.
Sean Park - I’d like to thank all the panelists. Thanks for joining us today and thanks for all the guests and people participating online. Appreciate your time.
First Republic does not provide tax or legal advice. Clients’ tax and legal affairs are their own responsibility. Clients should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this article.