Tax Management Update Q3 2021

Curt Overway, CFA®

Co-Head Natixis Investment Managers Solutions

As the third quarter drew to a close, Congress managed to pass a bill extending government funding

and President Biden signed it into law, averting a government shutdown. Attempts to pass the $1 trillion

bipartisan infrastructure bill stalled, however, as progressive Democrats in the House withheld their

support until Senate Democrats provide more clarity on the size and scope of the Build Back Better Act

(BBBA). President Biden and the Democratic Party leadership acknowledged the need to reconcile the

demands of both progressives and moderates and stopped pushing for passage of the infrastructure

bill until the party’s differences can be resolved. At this point it looks like passage of either bill is at least

a month away. The more progressive Democrats have been pushing for a $3.5 trillion BBBA, but key

moderates like Senators Sinema and Manchin have publicly stated they would not support a bill that

large, and Senator Manchin has indicated that his upper limit is $1.5 trillion.

More recently there has been discussion about a compromise somewhere between $1.9 and $2.3 trillion, although there are still many details to be negotiated. Passage of both bills now appears to be linked. The BBBA is probably the most relevant for tax policy as Democrats seek to use it to advance their social and environmental agenda, partly through spending but also via tax increases. The increased tax rates not only fund social programs but are also intended to address income inequality by focusing on corporations and the wealthy. Moderates have pushed both for a smaller bill and also for more modest changes to the tax code. With no hope of any Republican support, the Democrats will need to have every senator and virtually every member of the House from their party onboard.

Broad range of tax code changes under discussionPredicting the outcome of pending legislation is fraught with peril, but we thought it would be helpful to review some of the key tax code changes being discussed that would affect traditional investment portfolios. These include:

• Increasing the top federal income tax bracket from 37% back to 39.6%. This was one of President Biden’s original campaign proposals and has also been included in the draft bill from the House Ways & Means Committee. This new tax bracket would apply to individuals/households earning more than $400/450K. There seems to be little resistance to this provision, so there’s a good chance this ends up being part of the ultimate legislation.

• Raising capital gains tax rates for high income households. President Biden originally proposed taxing capital gains at the ordinary income rate (39.6% if the proposal above happens) for households earning over $1 million. The Ways & Means draft calls for a much more modest increase, from 20% to 25%, but it would apply at a lower income level – again at around $400–450K. Some moderate Democrats resisted the original proposal but see the increase to 25% as more palatable. The 3.8% Net Investment Income Tax (NIIT) would still also apply for higher income investors, and the Ways & Means draft would make this new rate retroactive to September 13, eliminating the potential for selling prior to the new rates going into effect.

Continued

Potential changes to US tax regulations that would affect investor portfolios are still under discussion.

• Eliminating the step-up in cost basis upon death. While President Biden proposed eliminating the step-up in basis, the Ways & Means draft does not. There has also been a lot of resistance to Biden’s proposal, especially from more moderate Democrats from rural states who worry about family farms getting caught up in this provision. Elimination of the step-up in basis therefore seems less likely. It is also less important if capital gains rates are not increased as much as in the president’s original proposal. Raising rates all the way to 39.6% (plus the 3.8% NIIT) was actually projected to reduce tax revenues since investors would be highly incentivized to avoid realizing gains. Combining that with the elimination of the step-up in basis and forcing the realization of gains upon death, however, turns that into a revenue generator. A more modest hike in capital gains rates is projected to increase tax revenues and help pay for the higher spending on its own.

• Changing the State and Local Tax (SALT) deduction. Some Democrats from blue states with high tax rates (e.g. California, New York, New Jersey) are pushing hard for this. Completely eliminating the cap on SALT deductions seems unlikely, however,asitwouldbenefitwealthierhouseholds,indirectconflictwiththestatedaimsofincreasingtaxesonthewealthy and corporations. Several Democrats have expressed strong demands that SALT be addressed, so even though the Ways &MeansdraftdidnotincludeanychangestoSALT,itispossiblethatthecapmightbeaddressedinanyfinalbill.Oneoption being discussed is a two-year repeal of the cap, and then possibly extending it beyond 2025 to offset the near-term revenue reduction. As a reminder, many of the provisions of the Tax Cuts and Jobs Act that related to personal income taxes are set to expire in 2025. Another possible approach would be to increase the cap, which also could be temporary.

• Establishing a high income surcharge. The Ways & Means draft included a new concept not included in the president’s original proposal – a 3% surcharge on income over $5 million.

• Increasing the corporate income tax rate. President Biden had proposed an increase from 21% to 28%, which would still be below the 35% rate in place prior to the Tax Cuts and Jobs Act. Moderate Democrats have voiced objections to an increase all the way to 28%, though there may be some consensus around a smaller increase to around 25%. The Ways & Means draftbillincludesanincreaseto26.5%forrevenueover$5million,withthefirst$400Ktaxedat18%,andthenext$4.6 million taxed at 21%.

• Taxing unrealized gains for high income households. Senator Wyden, the chairman of the Senate Finance Committee, has long advocated for a provision that involves an annual mark to market of investments, and the payment of taxes on unrealized gains. Earlier comments from Senator Wyden suggested this could apply to households with as little as $1 million in income, but more recently this proposal has been described as applying to “billionaires.” Such a policy would involve a lot of complexity and faces implementation challenges. At this stage this item seems unlikely to be included.

• Increasing funding for IRS enforcement. This was almost included in the bipartisan infrastructure bill, so is something that islikelyacceptabletomoderateDemocrats.Whilenotaffectingtaxratesspecifically,thiswouldaugmenttheIRS’sabilityto conduct audits and reduce tax evasion, with a focus on higher income taxpayers.

Asstatedabove,handicappingwhichprovisionsmightmakeitintofinallegislationischallenginggiventheverywiderangeofopinions,viewpointsandpoliticalfactorswithintheDemocraticParty.Whileitisdifficulttopredicttheoutcomeofthesediscussions, it is safe to say that for higher income investors, tax rates have nowhere to go but up. Higher tax rates mean more drag on investment returns from taxes, making tax management within investment portfolios even more important. Aswegetmorecertaintyaroundwhatspecificchangeswillgointoeffect,wewillupdateouranalysisquantifyingthat impact on investment returns.

Markets faced some headwindsThe markets got a bit bumpier in the third quarter, particularly in September. Economic growth was not as robust as expected, with the impact of the Delta variant, supply chain bottlenecks and labor shortages providing headwinds. Worries about how longsupposedlytransitoryinflationarypressuresmightpersistalsocontributedtoconcerns.TheS&P500® was down nearly 5%duringthemonthofSeptemberyetekedoutasmallpositivereturnforthequarteroverall.Onayear-to-datebasistheindexfinishedupstronglyat15.9%.Thedrawdownattheendofthequarterreached5.0%,exceedingthepreviouslargestdrawdownoftheyearwhichoccurredduringthefirstquarter.Amaximumdrawdownof5%isquitemodestbyhistoricalstandards.Overthelast20yearsonly2017hadasmallermaximumdrawdown(2.6%).

Tax Management Update – Q3 2021 (continued)

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FIGURE 1: Annual total return and max drawdown for the S&P 500® by calendar year

Q3 winners and losersThe S&P 500® remains up over 15% year to date, not all that different from where it stood at the end of the second quarter. However, the number of stocks that have declined over that period increased from around 10% at the end of last quarter to over 18% as of September 30.

FIGURE 2: Winners, losers and total return for the S&P 500® by calendar year

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Tax Management Update – Q3 2021 (continued)

Source: Thomson Reuters, Standard & Poor’s, Natixis Investment Managers Solutions Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

Source: Thomson Reuters, Standard & Poor’s, Natixis Investment Managers Solutions Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

Positive Movers Negative Movers Index Return

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During Q3 the return distribution was again more compressed than usual, similar to what we saw in Q2, with a more even balance between stocks appreciating and depreciating.

FIGURE 3: S&P 500® constituent quarterly return distribution for the trailing 8 quarters

Despite recent volatility, year-to-date returns still positiveThe returns across market segments were much more mixed for the quarter. Emerging markets and small-cap US stocks declined,whiledevelopedinternationalmarketsandlarge-capUSstockswereessentiallyflat.Onayear-to-datebasis,mostsegmentsstillhavedecenttostrongreturns,withthetwoexceptionsbeingemergingmarketequitiesandfixedincome. Large-cap US stocks have outperformed international developed markets. Growth stocks outperformed value stocks very modestly for both the quarter and year-to-date periods.

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Tax Management Update – Q3 2021 (continued)

Source: Thomson Reuters, Standard & Poor’s, Managed Portfolio Advisors and Active Index Advisors Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

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Tax Management Update – Q3 2021 (continued)

FIGURE 4: Year-to-date returns for select indexes

Source: Factset Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

Despitefairlyflatreturnsinmostmarketsegments,adrawdownof5%andanincreaseinthenumberofstocksdownfortheyear, the quarter still presented very limited opportunities for tax loss harvesting. This very modest market weakness comes on theheelsoffivestraightquartersofpositivereturnsfromthemarketlowsattheonsetofthepandemic.Othertaxmanagementtechniques, such as deferring the realization of short-term gains and choosing optimal tax lots, likely played a more prominent role than loss harvesting in many accounts. This type of environment does present opportunities to gift highly appreciated securities within client portfolios. For clients intending to make charitable contributions, this can be an effective way to avoid gain realization in the future. It does require a little coordination to avoid doing other rebalancing in the portfolio, but let us know if you’d like to explore this opportunity in any of your accounts.

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NATIXIS INVESTMENT MANAGERS SOLUTIONS – DIRECT INDEXINGNatixis Investment Managers Solutions provides design, development and execution of portfolio strategies tailored to specific investment objectives and unique portfolio constraints. Our Direct Indexing strategies can be customized to maximize after-tax return, align with personal values or pursue specific investment objectives.

S&P 500 Value: The index measures the performance of the large-capitalization value sector in the US equity market. It is a subset of the S&P 500 Index and consists of those stocks in the S&P 500 Index exhibiting the strongest value characteristics.S&P 500 Growth: The index measures the performance of the large-capitalization growth sector in the US equity market. It is a subset of the S&P 500 Index and consists of those stocks in the S&P 500 Index exhibiting the strongest growth characteristics.Russell 2000: Russell 2000® Index is an unmanaged index that measures the performance of the small-cap segment of the US equity universe.S&P 600 Small Cap: The S&P SmallCap 600 covers approximately 3% of the domestic equities market. Measuring the small-cap segment of the market that is typically renowned for poor trading liquidity and financial instability, the index is designed to be an efficient portfolio of companies that meet specific inclusion criteria to ensure that they are investable and financially viable.MSCI World ex US: MSCI World ex USA Index (Net) is an unmanaged index that is designed to measure the equity market performance of developed markets, excluding the United States.MSCI All Country World ex US: The MSCI All Country World Index ex US is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed (excluding the USA) and emerging markets. The index is shown with minimum dividend reinvested after deduction of withholding tax.MSCI Emerging Markets: MSCI Emerging Markets Index is an unmanaged index that is designed to measure the equity market performance of emerging markets.Bloomberg Barclays U.S. Aggregate: The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the US-dollar-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, government-related, corporate, mortgage-backed securities, asset-backed securities, and collateralized mortgage-backed securities sectors.

The views and opinions expressed may change based on market and other conditions. This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary.

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SOL84-0921R 2505446.11.2

EXP: 4/30/2022