The Cusp of Change

There is a history of this type of problem, of course, that is highly instructive, and the road is strewn with the wealthy who did not see change coming fast enough to correct future behaviors or they reacted to their past behaviors far too late to mitigate the risks caused by them. In the 1980s we saw the fall of Michael Milken, one of the greatest American financiers of all time. He knew that he was under constant scrutiny by the Securities and Exchange Commission due to his as best described “questionable” behavior in the high-yield bond and leveraged buyout space yet he continued to push the edge of the envelope.

Milken's role in these behaviors has been much debated over the years. In one book, April Fools, written by Dan Stone, a former Drexel Burnham Lambert executive, the author states that Milken viewed securities regulation with a degree of contempt, feeling that these rules hindered the free flow of trade and that Milken condoned questionable and illegal acts by his colleagues.

Milken ultimately pleaded guilty to six counts of securities and tax violations in 1990. Whether he truly committed these illegal acts or others is really of no significance. The real issue is that he should have seen that the world was on the cusp of change and accordingly altered his behaviors to minimize the risk of his past and future behaviors being criminalized with dire consequences.

The same can be said of foreign banks holding assets of U.S. citizens and certain long-term U.S. tax residents, and the U.S. taxpayers who owned these accounts. The failure to report income from offshore bank accounts was always illegal but for many years the Internal Revenue Service did little to regulate or enforce laws pertaining to offshore bank accounts. However, that policy was changed, and new laws were enacted to penalize banks and U.S. account holders of offshore accounts who did not comply.

Several large financial institutions were ultimately charged with helping Americans evade taxes, and hundreds of American taxpayers engaged in offshore banking with these institutions became the subject of grand jury investigations. Dozens of charges and convictions for tax evasion resulted, with many more cases in which individuals voluntarily agreed to pay delinquent taxes and sizable penalties rather than face criminal prosecution. Many bankers, accountants, and tax lawyers were also prosecuted for their roles in facilitating these transactions or advising clients as to how they could use offshore bank accounts to evade their reporting and tax obligations.

The consequences to these banks and account holders are another example of being caught on the cusp of change. Instead of mitigating the risks of past behaviors, many individuals instead sought to conceal their actions, transferring accounts to foreign entities, or moving accounts to other foreign financial institutions. Doing so only enhanced their exposures and made the consequences worse when they were ultimately discovered by the U.S. Government. The cover up is always penalized more than the base crime and knowledgeable counsel should have informed clients of this risk.

A Lesson from the Past

My primary strategic responsibility as an attorney who represents wealthy individuals and families is to identify, assess and mitigate legal risks. Of course, there are many types and varieties of risks such as income and estate tax, business, divorce, reputational, civil and criminal litigation exposures etc., and clients have their own personal risk quotient or their natural inclination of evaluating risk in the context of my advice and then choosing to accept, reject or mitigate these risks when they take certain actions or engage in certain activities. My job primarily is to give them a clear “look at the pitch” so that they can make an informed business decision about these risks.

I often say that my job is not to be their Priest or Rabbi, and I will do what they ask me to do, provided that their request is neither illegal nor unethical. But they must hear my views on the issue at hand.

It reminds me of the story of the lawyer and his client standing before the judge and the jury when the verdict is read by the foreman. The foreman says: “We find the defendant guilty” the client then turns to his lawyer and asks: “What happens next,” and the lawyer says: “I don’t know about you but I’m going to lunch.” The point is, once the lawyer identifies, assesses, and offers mitigation strategies to the client, it is the client who must then assume the responsibility for his or her actions or inaction.

Once I identify and assess a particular risk then it is also my job to address how to mitigate a particular risk; and then a similar type of assessment of these mitigation strategies needs to occur which ultimately results in my giving the client a menu of available alternatives which, again, assesses these mitigation strategies from a risk and reward stand point, along with the costs and complexities of each alternative.

Of course, because I have worked with many of the same individuals and families for many years this informs my advice and the alternatives I present. I already know their risk quotient for different types of risks. This is one of the reasons why I believe that highly effective private wealth lawyers are ones that have a holistic understanding of their clients over a long period of time.

Shifting Political Winds

What does this all mean in the current political climate and what, based upon current polling, is likely to happen after the election in November. To give some context, federal tax legislation can become effective on January 3, 2021 when the newly installed 117^th Congress officially convenes. Legislation may be introduced on that date and passed and signed into law later in the year and made retroactive to January 3, 2021 because there is no specific constitutional bar against retroactive tax legislation that increases a taxpayer’s tax liability.

Such legislation would likely be challenged in court on several grounds of course and in some cases retroactive taxes have been struck down based on due process concerns under the Fifth Amendment because of extended periods of retroactivity and a lack of notice of a new tax. Constitutional protections may also apply if the legislation appears to target certain taxpayers or it attempts to penalize past conduct.

Any retroactive tax legislation found to be a criminal penalty will also likely be struck down as a violation of the Ex-Post Facto Clause, and tax legislation that targets certain taxpayers might also raise concerns under the equal protection guarantees of the Fifth Amendment. These and other legal positions would take years to wind through the courts and many will be novel cases of first impression. In short, taxpayers fighting against potentially overreaching retroactive tax legislation would be fighting an uphill battle with the power of the U.S. Government against them.

What could this new tax legislation entail? Well, we already know what the presumptive Democratic nominee Joe Biden has proposed. Biden’s proposal would tax capital gains and dividends as ordinary income for taxpayers who report $1 million or more of such income, and tax capital gains at death. Currently capital gains and dividends are taxed at 20% plus a 3.8% net investment income tax or approximately 23.8%.

Biden would also raise the maximum tax rate from 37% to 39.6% so the tax rate on capital gains and dividends for these taxpayers will increase to 43.4% (39.6% plus 3.8%) before any state and local taxes. Currently built-in, untaxed gains go untaxed at death but are potentially subject to a 40% estate tax. Under this proposed change these gains would likewise be taxed at 43.4% at death plus a potential estate tax of 40% (presumably on the balance of the assets’ total value after payment of the income tax on the built-in gain).

The estate tax will also affect more taxpayers than is  currently the case because Biden has already stated that he would repeal major provisions of the 2017 Tax Cuts and Jobs Act (TCJA) presumably including eliminating what is currently a $11.58 million per person and $23.16 million per married couple estate tax exemption. The $11.58 million estate exemption for 2020 is currently scheduled to remain in place and may even increase slightly from year to year because it is regularly adjusted for inflation, but it is slated to expire after 2025.

If Congress were instead to repeal the estate tax exemption next year then the exemption would revert back to the pre-2018 level of $5.49 million ($10.98 million for married couples) or perhaps even lower if more aggressive tax pruning takes  place beyond just repeal, thus subjecting many more assets and family wealth at death to both income tax at ordinary income rates on any untaxed gain and a 40% estate tax on the remaining value of the estate.

The Biden proposal would also increase the corporate tax rate to 28% from its current 21% and would phase out the special reduced flow-through tax rate of 29.6% on business income and instead tax this income at regular ordinary income tax rates of a maximum of 39.6% for taxpayers with income above $400,000 per year.

In addition to the increased maximum 39.6% income tax rate, taxpayers currently are and will continue to be subject to three additional taxes on their salary, wages, self-employed income, and other compensation income or so called “earned” income. These three additional taxes are social security taxes (currently at 12.4%), Medicare tax (currently 2.9%) and an additional Medicare tax (currently 0.9%). The self-employment tax rate is 15.3% of net earnings, the total of the 12.4% Social Security tax and the 2.9% Medicare tax on net earnings. The additional 0.9% additional Medicare tax also applies on net earnings from self-employment exceeding $200,000 for single filers or $250,000 for joint filers; however, for 2020, only the first $137,700 of earnings is subject to the Social Security tax of 12.4%.

Taxpayers who are not self-employed and who receive W-2 salary and wages split the Social Security and Medicare taxes (i.e., employee pays 7.65% and the employer pays 7.65%); self-employed people pay both halves for a total of 15.3%. Therefore, the short-hand way of describing the tax rate for high earners was always to say it was 40.8%, 37% maximum tax rate plus the two Medicare taxes totaling 3.8%.

Under the Biden proposal, this rate will increase to 55.8% before state and local taxes for taxpayers earning more than $400,000 per year because the maximum income tax rate will increase to 39.6% plus the Medicare taxes of 3.8% plus the Social Security tax of 12.4% will now also apply to these earnings over $400.000.

Separate from income and estate tax increases there was also discussion during the campaign for enactment of a wealth tax. Senator Elizabeth Warren’s Ultra-Millionaire Tax proposal would tax net worth above $50 million and below $1 billion at 2% per year and net worth above $1 billion at 6% per year. Senator Bernie Sanders’s wealth tax proposal would levy a 1% tax per year on net worth above $32 million, for married couples, and then an increase in the tax for wealthier households: a 2% tax for net worth  between $50 to $250 million; 3% tax for net worth from $250 to $500 million; 4% tax from $500 million to $1 billion; 5% from $1 to $2.5 billion; 6% from $2.5 to $5 billion; 7% from $5 to $10 billion; and 8% on wealth over $10 billion. These brackets are halved for single taxpayers.

More mainstream proposals have also been offered that utilize the current tax system to achieve a similar result as the Warren and Sanders wealth tax ideas. For example, Senator Ron Wyden (D-ORE.) the ranking Democratic member of the Senate Finance Committee last year offered a “market to market” capital gains tax on taxpayers with more than $1 million of annual income or more than $10 million of assets.

Under current law, investors are not required to pay taxes on capital gains which accrue to their assets until they are sold. Under the Wyden proposal an anti-deferral rule would subject these unrecognized gains to current taxation. In combination with the Biden proposal, this would tax unrecognized capital gains at 43.4% as described above.

Electoral Chances

All these tax changes could become effective in January of next year, so the question becomes: how likely is that to occur? Certainly, based upon swing state polling, Joe Biden would likely be elected President if the election were held today. Other more limited polling though, indicates the Democrats also have a strong chance of wresting control of the Senate.

Senate Republicans have 23 seats to defend, compared to the 12 Senate Democrats who are up for reelection. Democrats would need to win back at least three seats to reclaim the majority in the Senate, but they are also defending Senator Doug Jones’ seat in Alabama — a state where President Trump has a very high approval rating. Were Senator Jones to lose Democrats would need to win four seats and the White House (where their party’s vice president could vote to break ties in the Senate), or net five seats without the White House advantage.

Taking a closer look: four states looked highly competitive for Democrats: Colorado, Arizona, Maine, and North Carolina. It looks to be very close in Colorado too, with the ultimate Democratic nominee—either former Gov. John Hickenlooper or former speaker of the Colorado state House Andrew Romanoff—facing off against Republican incumbent Sen. Cory Gardner.

In Arizona, Democrat Mark Kelly has a big early polling lead over Republican incumbent Martha McSally; he has been up by no less than 5 points and as much as 13 points in every poll since March. In Maine, Republican incumbent Susan Collins has been behind Democratic challenger Sara Gideon in every poll since February but by only a small margin.

In North Carolina, Republican incumbent Thom Tillis looks to have a slight polling advantage over Democratic Cal Cunningham, but it could still go either way. The Republicans could pick up a seat in Alabama, a state where President Trump remains popular, where either former Republican Senator Jeff Sessions or former Auburn University football coach Tommy Tuberville will run against the incumbent Democratic Senator Jones.

But several additional seats are now in play for Democrats as well, including in Montana—where incumbent Republican Senator Steve Daines is running against term-limited Governor Steve Bullock—and in Georgia’s regular and special Senate elections. In the regular election, a recent poll showed that incumbent Senator David Perdue leads Democratic front-runner Jon Ossoff by only 2 points; and, a recent Georgia survey showed a statistical tie between three candidates in the state’s special election to serve out the rest of retired Republican Senator Johnny Isakson’s term. Republican Representative Doug Collins received 19%, while incumbent Republican Senator Kelly Loeffler, who was appointed to Isakson’s seat last year, scored 18% in the poll. Just behind the two Republicans was Democrat Matt Lieberman at 17%.

Republicans are also very concerned about retaining a seat in Iowa, where Republican incumbent Senator Joni Ernst is slightly trailing her Democratic challenger Theresa Greenfield in two recent polls

The bottom line is that if Biden defeats Trump; a Republican wins in Alabama as most expect; and Kelly wins in Arizona, as currently projected, then the Democrats would only have to win three more Senate elections to control the Senate, with close races seemingly under way in Colorado, Maine, North Carolina, Montana, Iowa and the two Senatorial elections in Georgia. By all indications, the margin of error for either party this election cycle is going to be razor thin.  That will make for an exciting November for many Americans but, for my clients, an especially fraught one. To them, the very real possibility of Democrats controlling the Presidency and both chambers of Congress is concerning to say the least.

No Exit

The United States imposes an exit tax when U.S. citizens and certain long-term residents relinquish either their citizenship or their green cards. The exit tax affects expatriates who have a net worth of $2 million, or a 5-year average income tax liability exceeding $168,000 as adjusted for inflation.  Expatriating taxpayers are treated as if they had sold all their assets on the date prior to their expatriation. Net gain is the difference between the fair market value and the taxpayer's cost basis in the assets deemed to be sold. Once net gain is calculated, any net gain greater than $600,000 will be taxed as income in that calendar year.

Warren and Sanders had plans to add a second layer of exit taxes. Warren’s tax proposal was a 40% tax on all assets above $50 million for an individual ($100 million for a couple). Sanders’ plan was 40% above $16 million ($32 million for a couple) and 60% above $500 million for an individual and $1 billion for a couple. I think that it is safe to say that should the Democrats control both Houses of Congress and the Presidency, they will make it quite difficult for the wealthy to escape the U.S. tax system, raising taxes so substantially that expatriation will become onerous.

Other Changes

Besides these potential tax changes, what else can the wealthy expect should Biden be elected, and the Democrats gain control of the House and Senate? I suspect there will be stricter enforcement of our laws, especially those that affect the actions and activities of the wealthy.

Regulatory transgressions that might previously have been civil matters or addressed via financial penalties or sanctions, could become criminalized with the alleged wealthy perpetrator’s liberty at stake and the wealthy should not expect to be judged by a jury of their peers. The presumption will be that that the wealthy or their ancestors obtained their wealth unfairly, by subjugating the poor or perpetrating injustices on the marginalized in our society. 

These attacks will not be limited to those of one political party or the other. No one will care what causes the targeted individual supported, they will be treated uniformly with the only goal of showing that laws are being administered fairly and consistently. All wealth, no matter how it is accumulated, will be demonized. Any perceived transgression, even if caused by a distant family member or attributable to an organization only tangentially associated with an individual, will be weaponized. Every well-meaning charitable contribution will be highly scrutinized.

Erosion of Safety

Will government protect the wealthy, or must they fend for themselves? All indications are that the wealthy will need to protect themselves, and I would be investing heavily in personal security related concerns. Most of my clients already have private security but many have substantially expanded and enhanced their protection-related personnel.

Because of COVID-19 and recent civil unrest, many of my clients have left major metropolitan areas or are only going to them when necessary. If they do return more permanently, they will be taking much greater security precautions, though many have already put their city homes on the market for sale or rent. The words we have heard from police chiefs and City officials make clear that they will not put property over people. If the government is not going to protect the property of the wealthy, who will? Under such circumstances, drastic changes in how they conduct their activities, make their investments, and live their lives rapidly become a necessity.

Conclusion

Nothing in this article is intended as a political statement. I am blessed to represent clients who identify as Democrats, Republicans, and Independents. I also believe that no matter who holds political office next year that income tax rates are likely to go up over the next few years to pay down large deficits caused by the legislation in response to the Pandemic.

Instead I concern myself with “realpolitik” or the coercive effect of politics on my clients. I try to identify and assess risks associated with this potential coercion and offer mitigation strategies for my clients so that they minimize the effects of the tsunami of political change allowing them to survive, prosper and live to fight another day.