The Capital Gains Rate - Historical Perspectives on "Retroactive" Changes

In light of the U.S. presidential election on 3 November 2020, many investors and business owners expecting a liquidity event are focused on the possibility that the current capital gains rate (generally, 23.8 percent) could be subject to significant change, including potentially taxing long-term capital gains at higher ordinary income rates for certain filers. While overarching considerations weigh heavily in the context of voting decisions and private business sales alike, history suggests that, faced with the prospect of a potentially changing federal income tax rate, waiting to see legislative change might foreclose opportunities to realize gains at current favorable rates. In particular, the conventional wisdom is that any significant U.S. tax bill enacted after the election (and assuming a Democratic victory in the presidential race as well as Democratic gains in the Senate), would not be enacted until well into in calendar year 2021. This leads to the question of whether gains from transactions completed in 2021, but prior to such legislative change, could be subject to a higher capital gains rate. 

A historical review suggests that any tax legislation enacted in 2021 could have retroactive effect to transactions completed at any time in 2021. In recent years, such retroactive rate changes have occurred as late into the year as August. The chart below sets forth a list of recent tax legislation impacting individual income tax rates and, often, capital gains rates specifically. Of course, this history does not encompass or limit the universe of potential changes. Certain proposals, such as the marking-to-market of capital gains, may impact the timing of capital gains in addition to the rate. Conversely, proposals such as indexing capital gains to inflation could effectively reduce the rate of tax by applying the same rate to a lower tax base.

Notably, these examples involved only rate decreases, which are typically easier to implement on a retroactive basis from a political standpoint. Rate increases generally have been scheduled by prior legislation. However, this recent experience does not foreclose the possibility that a capital gain rate increase could be implemented on a retroactive basis. Most recent significant tax law legislation included at least some retroactive elements. The only change to individual income rates or brackets in recent experience that applied solely to prospective tax years was the TCJA, signed into law in December of 2017 and first applicable for calendar year 2018. While the most significant recent capital gains rate change, provided by the JGTRRA, was largely prospective, it was still, in part, retroactive and included a complicated transition rule that functionally split the single calendar year 2003 into two periods for purposes of computing the capital gains tax. It, nevertheless, remains possible that we see even further retroactivity for certain concepts where the sponsors of the legislation believe the public has had fair warning. 

Where life’s only certainties are death and taxes, and only one of those is even marginally predictable, the tax implications of a transaction would ideally be known at the time of closing. However, because tax legislation enacted at any time in 2021 could potentially apply to all transactions occurring in 2021, investors and business owners expecting a liquidity event should consider completing their intended transactions on or before 31 December 2020 if they would like more assurance that they will benefit from the current long-term capital gains rate.