By Mallon FitzPatrick, CFP®, Managing Director, and Stuart Katz, Chief Investment Officer
August 29, 2022 – After considerable back and forth between lawmakers and the White House, President Joe Biden signed the Inflation Reduction Act (IRA) into law on Tuesday, August 16, 2022. The approximately $485 billion spending bill is offset by a forecasted $790 billion in revenue raising measures. The bill is a watered-down version of the original $3.5 trillion Build Back Better Act that failed to pass in the Senate. The IRA contains several initiatives and attempts to reduce prescription drug prices for Medicare recipients and provide for climate and energy spending by incentivizing renewable energy projects and offering tax credits.
Given the breadth of the bill and the sizable spending attached to it, it’s natural to wonder what it may mean for your wealth plan and investment portfolio. Here’s a breakdown:
An Augmented IRS
The Inflation Reduction Act was passed as a reconciliation bill and its spending provisions must be paid for by revenue-raising measures. Although there are some tax changes in the legislation, none directly increase personal income tax. However, the federal agency responsible for tax enforcement, the IRS is receiving $80 billion in funds over the next decade.
The investment is expected to boost the capacity for enforcement and will likely increase staff numbers and modernize antiquated technology resulting in a gradual increase in audits. This latter point doesn’t apply indiscriminately to all taxpayers; as officials have repeatedly stressed, the agency’s increased funding will be dedicated toward corporations and wealthy tax evaders who’ve avoided scrutiny in the past. The IRS currently has fewer experienced examiners in the field than at any time since World War II, and fewer employees than at any time since the 1970s. Audits of individual taxpayer returns decreased for all income levels from 2010 to 2019. On average, a taxpayer was three times less likely to be audited in 2019 than they were in 2010. During this time audit rates decreased the most for high income taxpayers.
In a recent letter addressed to the Senate, IRS Commissioner Charles P. Rettig assured lawmakers that the agency would not be increasing audits for households making under $400,000. Referencing the need for additional funding, he stated:
“The IRS has for too long been unable to pursue meaningful, impactful examinations of large corporate and high-net-worth taxpayers to ensure they are paying their fair share,” he wrote. “This creates a direct revenue loss from evaders and lessens the potential to deter others from pursuing a similar path of noncompliance. Every American should support a fair and impartial system of tax administration supported by an appropriately resourced tax administrator.”
Keeping an Eye out for Audits
The IRS’s dearth of resources in recent years has resulted in a decrease of audits as well as fewer lawsuits filed for tax evasion. Recently, however, the IRS has increased audits on high income households. According to data published by the Treasury Inspector General for Tax Administration, the percentage of 2019 tax returns audited in the 7-month period between Sept 30th, 2021, and May 1st, 2022, doubled for taxpayers with income between $500k-$10mm and quadrupled for those with greater than $10mm.
The press focuses on income tax, but few people realize that the IRS is far more inclined to audit estate tax returns. The greater an estate’s value, the more likely it is to be audited – depending on the individual’s wealth, an estate tax return can be between 10 to 20 times more likely to be scrutinized by the IRS than an income tax return. The agency is in the process of escalating its efforts and it’s important ensure the proper documentation is in place for gifting and valuations.
This extends to making sure properties within the estate are appropriately appraised. When a large portion of an estate’s value is tied up in real estate or a non-publicly traded business, the IRS takes notice. This axiom also applies to any art, antiques, or collectibles. The agency may also examine the valuation of gifts given during the deceased’s lifetime. Again, it is important to properly appraise and document any gifted private company stock, property, and discounted valuation of LLC interests.
Other techniques that are more likely to be challenged include gifts that are technically not gifts; sales of assets directly to children or an Intentional Defective Grantor Trust (IDGT) funded with intra-family loans. Likewise, Irrevocable Life Insurance Trusts (ILIT) are also prone to examination by auditors. The policy and trust documents may be examined to see if the deceased held any beneficial interest in the policy.
To help avoid any estate tax headaches, our recommendation is to ensure the valuation of gifted and inherited property or LLC discounted valuations are properly documented and to use a qualified appraiser where applicable.
The Effect on Corporate Earnings
Although personal income taxes may have emerged from the Inflation Reduction Act unscathed, the same can’t be said for corporate taxes. As part of the bill’s revenue raising proposals, American companies are now subject to a corporate minimum tax of 15%.
Keeping returns in mind, this means corporate earnings are likely to be reduced at the margin. Indeed, some Wall Street firms are estimating that between 0.5% to 1% could be shaved from larger companies’ S&P 500 earnings within the first year of the law taking effect. This reduction in profits could motivate companies to lower employees’ compensation or reduce their work force in an effort to retain earnings. From an investment perspective, reduced earnings will likely have a ripple effect impacting company performance, in turn causing slightly lower portfolio returns that may necessitate an adjustment of long-term plans.
Additionally, the act includes a 1% excise tax on stock buybacks from large corporations. While buybacks in the S&P 500 have been strong for some time, according to Goldman Sachs, the new levy would reduce earnings per share by roughly 0.5%. While this new fee isn’t expected to inhibit corporate buybacks in the immediate future, it is worth watching out for its effect on rising recession fears in the coming months.
In summary, the Inflation Reduction Act redistributes wealth from one sector to another. While this may yield long-term benefits stemming from reinvestments over the act’s ten-year span, in the short-term, the corporate sector may be adversely affected.
Mitigating Medical Expenses
One of the bill’s most far-reaching changes concerns health care costs for Medicare enrollees. The Act contains measures designed to lower prescription drug prices by allowing the government to negotiate prices for the first time. Under the legislation, the United States Department of Health, and Human Services (HHS) can negotiate prices for some of the most expensive drugs covered under Medicare Part B and Medicare Part D; the former covers specialized drugs administered by health care providers, while the latter encompasses drugs that are filled at retail pharmacies. Furthermore, the Act also caps Medicare recipients’ out-of-pocket drug costs at $2,000 annually, currently there is no cap . It’ll be a few years before these policies take effect – the out-of-pocket cap starts in 2025, and the HHS will gain the ability to parley drug prices in 2026.
Medicare recipients are one of the biggest beneficiaries of the Inflation Reduction Act, and the changes should go a long way toward making health care more affordable for the elderly and retirees. According to a report by RBC Wealth Management, health care is expected to cost the average retiree more than $400,000k over their remaining lifetime – notably, this estimate does not factor in the cost of long-term care, which averages at approximately $110,000 per year.
Looking at these Medicare adjustments from a wealth planning perspective, capped out of pocket expenses are likely to reduce the amount of money needed to fund retirement. However, for those with assets and investments in pharmaceutical companies, the government’s ability to negotiate drug prices for Medicare enrollees may impact earnings. With that said, the legislation pertaining to drug prices is limited and impacts a small number of larger companies that have more exposure to Medicare. As analyzed through the letter of the law, many research analysts expect any effect on investments to be manageable. Perhaps more pivotally, it opens the door for increased government involvement in drug pricing which could lead to multiple compression in pharma over time.
The bill also includes a three-year extension of the premium tax credits allowing high-income households to continue taking advantage of the refundable tax credit to help cover insurance premiums.
Taking Full Stock of Green Initiatives
Another provision of the IRA extends the $7,500 electric vehicle (EV) tax credit from 2023 through the end of 2032 and removes the per manufacturer limit of 200k vehicles. There are personal income limits and other restrictions, and this bill seems to be aimed at encouraging mid to mid-high-income taxpayers to purchase EVs assembled in the US.
For those seeking to invest in reducing their carbon footprint and potentially save money on energy costs, the bill contains various rebates and tax credits. Here are some of the major provisions:
- 30% tax credit for the installation of solar panels or other equipment to harness renewable energy such as wind, geothermal and biomass fuel
- $2,000 a year credit for the installation of certain efficient home systems that are approved including some heat pumps, water heaters, and biomass boilers
- Up to $2,000 for home-energy rebate programs if the taxpayer reduces their energy usage by 20% and $4,000 for a 35% reduction. Lower income households can qualify for up to $8,000 in rebates
- Up to $14,000 in tax credits for the high-efficiency electric home rebate program that targets certain appliances[1]
From an investment perspective the ebb and flow of renewables incentives over the past decade in the U.S. have created volatility around long-term growth projects. However, in the absence of policy support renewables have been scaling on their own, given cost declines, and benefits, such as more flexible power sources, and ability to provide electricity with no water use, unlike fossil fuels. The IRA policy package does provide an important accelerant for climate change adaptation and mitigation and will catalyze several green themes and industries.
It’s fair to say that the Inflation Reduction Act contains many provisions that could directly or indirectly impact your wealth plan and investment portfolio. A strategy to take advantage of multiple provisions within the IRA are to take the expected savings from drug costs, to fund home energy projects, and to allocate the existing investment portfolio toward themes and industries that are likely to benefit from the tax incentives. The opportunity may be five-fold: (i) a subsidized upgrade of home systems, (ii) an investment in industries that may see increased demand for these systems which may increase earnings (iii) a likely reduction of ongoing home energy costs, (iv) a reduced carbon footprint, and (iv) engagement in projects that take up extra free time. Please reach out to your wealth manager to explore the Act’s planning and investment opportunities that align with your values and objectives.
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[1] https://www.kiplinger.com/taxes/605069/inflation-reduction-act-tax-credits-energy-efficient-home-improvements
