Major Tax Changes in Draft Reconciliation Bill
As negotiations over spending and taxes in a potential budget reconciliation bill (tentatively the “Build Back Better Act”) are ongoing in Congress, Democrats on the House Ways and Means Committee on Sept. 13 released the draft text of their proposed tax-raising provisions, which was the subject of a committee markup session two days later and has now been approved by the committee.
Below is a summary of certain key provisions in the proposal that may be most relevant to our clients. The below does not cover all of the proposed changes, so please contact a Waller tax attorney to discuss how the proposals could impact your specific tax circumstances. These provisions are subject to ongoing negotiations, and some are more likely to pass than others.
In addition to the proposals described below, some other major changes are being considered in Congress that are not part of the draft text. One potential change would ameliorate the current $10,000 limit on the deductibility of state and local taxes for individuals. Another proposal would require financial institutions to report activity in most financial accounts directly to the Internal Revenue Service.
All references to a “Section” below are to sections of the Internal Revenue Code.
Long-Term Capital Gains Tax Rates
Under the proposal, for tax year 2022, individuals could face a 31.8% combined tax rate on long-term capital gains (a 25% capital gains rate, plus 3.8% net investment income tax, plus 3% surtax).
The proposal would increase the top long-term capital gains tax rate to 25% from 20%. Importantly, as the legislation is drafted this change would be effective in 2021, with gains from transactions completed on or before September 13, 2021 still subject to a 20% top rate, along with gains recognized pursuant to certain binding contracts entered into on or before September 13, 2021. Gains arising after September 13 would be subject to the 25% top rate. Also, effective in 2022, the level of income for individuals to be in the top capital gains and ordinary income tax bracket would be reduced to $450,000 for a married couple filing jointly, or $400,000 for unmarried individuals.
The additional 3.8% net investment income tax would still apply, on top of the capital gains rate, to most investment income. In addition, as described further below, the 3.8% tax would be modified to also apply to income and gains from an active business for high-income taxpayers, but this change would not be effective until 2022.
In addition to the above, a 3% “surtax” would apply to all income of individuals with modified adjusted gross income over $5 million ($2.5 million if married, filing separately). This change would start in 2022.
Ordinary Income Tax Rates
Under the proposal, for tax year 2022, individuals could face a 46.4% combined tax rate on ordinary income (a 39.6% ordinary rate, plus 3.8% net investment income tax or self-employment tax, plus 3% surtax). The top ordinary income tax rate would increase to 39.6% from 37% and would begin to apply at an income level of $450,000 for married couples filing jointly, or $400,000 for unmarried individuals. As noted above, an additional 3% surtax would apply for taxpayers with adjusted gross income of over $5 million ($2.5 million if married filing separately). Both of these changes would also apply beginning in 2022.
Net Investment Income Tax
The proposal would make changes to the application of the existing 3.8% net investment income tax. Under current law, the 3.8% tax does not apply to income from businesses where the taxpayer is considered to materially participate (an “active business”), including gain on the sale of partnership interests or S corporation stock to the extent the gain is attributable to active business assets. Under the proposal, the 3.8% tax would apply to active business income for taxpayers with income above $500,000 for married couples filing jointly, or $400,000 for unmarried individuals, subject to a phase-in. This proposed provision does clarify that income subject to FICA or self-employment tax (also a 3.8% total rate) would not also be subject to the 3.8% net investment income tax.
Tax Rates on Trusts and Estates
Estates and non-grantor trusts have traditionally been subject to the highest tax rates with very little benefit from graduated tax brackets on their taxable income that is not carried out to beneficiaries. The proposals here are no exception: the 25% rate on capital gains and 39.6% rate on ordinary income would apply to trust income in excess of approximately $13,450. The 3.8% net investment income tax (also applying to active business income) would also apply at that level of income, and the 3% surtax would apply if income exceeds $100,000. In addition, the repeal of the 100% exclusion under Section 1202 (described below) would apply to all trusts and estates.
Cap in Benefit from Flow-Through Deduction
Under current law, subject to numerous exceptions and limitations, taxpayers that are not corporations or noncorporate owners of pass-through entities (i.e., S corporations and partnerships) engaged in a qualified trade or business are generally permitted a 20% deduction of the ordinary income allocable to them from the business under Section 199A.
The proposal would, effective beginning in 2022, limit the amount of the 20% deduction to $500,000 for married individuals filing jointly, $250,000 for married individuals filing separately, $10,000 for an estate or trust, and $400,000 for all other taxpayers.
Carried Interest Changes (Section 1061)
Under current law, certain long-term capital gain attributable to profits interests granted to a taxpayer in connection with the performance of substantial services (commonly referred to as “carried interests”) in certain investment partnerships, such as hedge funds, private equity funds, and real estate funds, are subject to ordinary income tax rates, instead of long-term capital gains tax rates, if the asset giving rise to such gain was not held for more than three years. Gain that is not technically long-term capital gain but that is treated the same (such as gain from the sale of property used in a trade or business -- so-called “Section 1231 gain”), is not currently subject to this three-year holding period rule. Many real estate funds hold their assets in connection with a trade or business such that substantially all of the gain from such funds is Section 1231 gain, effectively exempting such funds from this carried interest, three-year holding period rule.
Under the proposal, Section 1231 gain or any other gain subject to tax at the rate applicable to long-term capital gain would also be subject to the special carried interest provision. Additionally, the holding period required for an applicable carried interest to be taxed at long-term capital gains rates would increase from three to five years for most funds. Notably, the three-year holding period would be retained for interests in partnerships engaged in a real property trade or business within the meaning of Section 469(e)(7)(c) or for taxpayers (other than a trust or estate) with adjusted gross income of $400,000 or less.
The proposed carried interest changes would be effective beginning in 2022.
Reduction in Benefit from Sale of Qualified Small Business Stock (Section 1202)
Under current law, a taxpayer (other than a C corporation) who disposes of “qualified small business stock” acquired after 2010 and held for more than five years can exclude from taxable income 100% of the gain (up to $10 million) recognized from the sale.
Under the proposal, the gain exclusion would be reduced from 100% to 50%. Further, the remaining 50% of the gain not excluded is “Section 1202 gain” subject to tax at a 28% rate, instead of the 25% rate normally applicable to long-term capital gain under the proposal. The result of the change is an effective rate of 15.9% (50% of 25% + 3.8%) if the taxpayer is not subject to the 3% surtax on individuals with adjusted gross income over $5 million (as discussed above) or 17.4% (50% of 25% + 3.8% + 3%) if the taxpayer is subject to the surtax.
The proposal would apply to sales of qualified small business stock occurring after September 13, 2021, other than sales occurring pursuant to a binding written contract which was in effect on September 12, 2021. (The proposal actually provides that the amendment would be applied to sales made on or after September 13, 2021, but the actual wording of the amendment only applies to sales made after September 13, 2021.)
Corporate Rate Changes and Effective Date
Under current law, corporations are subject to a flat tax rate of 21% on all taxable income. Under the proposal, the flat 21% tax rate would be replaced with graduated rates and a top bracket at 26.5%. Specifically, the corporate tax rate would be 18% of taxable income up to $400,000, 21% of taxable income in excess of $400,000 up to $5,000,000 and 26.5% of the amount in excess of $5,000,000, with an additional tax on corporations with taxable income in excess of $10,000,000 designed to eliminate the reduced rate benefits for taxable income in the lower brackets. These new corporate income tax rates would go into effect in 2022.
Syndicated Conservation Easements
In concert with the IRS’s ongoing enforcement efforts related to abusive conservation easement transactions, the proposal would generally limit the amount of a partner’s deduction for a qualified conservation easement donated by a partnership to 2.5 times the partner’s allocable basis in the real estate. Similar provisions would apply to S corporations and other passthrough entities. An exception would be available in situations where the partnership, as to the real estate, and the partners, with respect to the partnership, have held their interests for at least three years. This provision would apply retroactively to contributions made after December 23, 2016, which is the date of the IRS notice that made certain syndicated conservation easement transactions “listed transactions” for tax purposes. The proposal would also enhance certain penalties and adjust the application of the statute of limitations for relevant transactions.
One favorable aspect of the proposal is that donors of easements that are not considered abusive would generally have an opportunity to correct an unintentional “foot fault” in an easement deed within 90 days from the date the donor is notified of the defect by the IRS. This could mitigate the impact of case law related to transactions the IRS has deemed abusive on donors in non-abusive scenarios.
Decrease in Estate, Gift and GST Exemption Amounts
The proposal would remove the provision that doubled the basic exclusion amount for estates of decedents dying or gifts made between January 1, 2018 and December 31, 2025 from $5 million to $10 million (both figures subject to inflation adjustment). The elimination of this provision would cause the basic exclusion amount, and along with it, the generation-skipping transfer tax exemption, to revert to $5 million per person (or, adjusted for inflation, $6.02 million), effective January 1, 2022. The basic exclusion amount is a set dollar amount that an individual can give away before or at death without the application of estate or gift taxes.
Increase in Downward Adjust of Valuation on Farm Property
The proposal would increase the permissible amount of the downward adjustment on estate tax valuations for certain real property used in farming from $750,000 to $11.7 million, effective January 1, 2022. The increase is designed to avoid the application of estate tax attributable to a valuation on farmland based on the highest and best use of the real property, which is often not for farming purposes.
Changes to Grantor Trusts
The proposal adds two new Sections applicable to grantor trusts created on or after the date of enactment, as well as to contributions made to grantor trusts on or after the date of enactment. One new Section would cause the entire value of a grantor trust to be included in the grantor’s taxable estate at the grantor’s date of death. Under current law, the grantor may make a gift to a trust, and, if the grantor retains certain powers, the trust is treated for income tax purposes as the same person as the grantor, while nonetheless being excluded from the grantor’s estate for estate tax purposes. As such, the current income tax treatment of grantor trusts allows the grantor to make tax-free gifts to the trust beneficiaries by paying the income tax liability of the trust while otherwise removing the trust property from the grantor’s taxable estate. The second new Section would cause gain recognition for income tax purposes on sales or exchanges of property between a trust and a deemed owner (the grantor), eliminating the benefit of sales to grantor trusts under current law, which can be made without recognizing gain.
Elimination of Valuation Discounts for Passive Assets
The proposal would add provisions applicable to the valuation of entity interests owned at death and to entity interests transferred by gift. These provisions would prohibit the application of a valuation discount to an entity’s “nonbusiness,” or passive assets transferred after the date of enactment, eliminating discounts for entities other than for entity assets used in an active business.
No Change to Adjustment of Basis at Death
The basis of most property acquired from a decedent is the fair market value of the property at the date of the decedent’s death. Because of asset appreciation and inflation, that change in basis is often a step-up from the decedent’s cost basis. Referred to as a “loophole” by Senator Chris Van Hollen, his proposed STEP Act sought to tax unrealized gains at death. The current proposal, however, would not provide any changes to the adjustment of basis at death.
401(k) and IRA changes
The proposal would make significant changes to IRAs and defined contribution plans (such as 401(k) plans) for high net worth individuals and their beneficiaries. Specifically, for high income earners (defined as $450,000 for married taxpayers filing jointly, $425,000 for head of household taxpayers, and $400,000 for single filers (with these amounts subject to inflation adjustment), the proposed legislation would prohibit additional contributions to both traditional and Roth IRAs if the aggregate value of the taxpayer’s IRAs and defined contribution retirement accounts exceeds $10,000,000. Moreover, high income earners with IRAs and defined contribution retirement accounts with aggregate balances in excess of $10,000,000 would be required to take a minimum distribution equal to 50% of the amount in excess of the $10,000,000 threshold (apart from an otherwise required minimum distribution). This proposed additional required minimum distribution is more punitive if the taxpayer’s retirement accounts exceed $20,000,000 in the aggregate.
The proposal would largely prohibit “back-door” Roth IRA conversion for high income taxpayers. In general, a back-door Roth IRA conversion occurs when a taxpayer makes nondeductible contributions to a traditional IRA and then converts the traditional IRA to a Roth IRA. The proposed legislation would prohibit high income earners from such Roth IRA conversions, as well as disallow after-tax contributions to employer qualified plans, and the conversion of after-tax IRA contributions to a Roth IRA, irrespective of adjusted gross income levels.
Lastly, the proposal would prohibit an IRA from holding any securities that are required to be held by Accredited Investors (under Securities and Exchange Commission rules). An IRA that holds such proscribed investments would lose its IRA status following a two-year transition period for existing IRAs. The legislation would also deem the owner of an IRA to be a disqualified person for purposes of the prohibited transaction rules of Section 4975, and would prohibit IRAs from investing in entities of which the IRA owner owns a 10% or greater interest (as opposed to the current limitation of 50%).
Tax-Free Conversion of Certain S Corporations to Tax Partnerships
The proposal would create an opportunity for S corporations that have continuously been S corporations since May 13, 1996 to convert to partnership form (e.g., an LLC taxed as a partnership) without triggering the tax on the built-in gain in assets that would normally apply when assets are distributed out of a corporation.
With the proposed 3.8% net investment income tax on active business income described above, S corporations generally would not have an advantage over partnerships in terms of the effective federal tax rate on operating profits (partnerships could actually have a small advantage given the partial deductibility of self-employment tax) for high-income taxpayers, and S corporations could also be less advantageous from a Tennessee excise tax perspective.
Because partnerships are far more flexible than S corporations from a federal tax perspective, clients who may be eligible to make this conversion should carefully consider doing so if this provision is enacted.
Wash Sale and Constructive Sale Rules to Apply to Cryptocurrencies
The proposal would expand two tax rules that currently apply to stock and certain other securities to cryptocurrencies: the wash sale rule and the constructive sale rule. The proposal would also add a related party provision to the wash sale rule.
The wash sale rule under Section 1091 provides that a tax loss from the sale of a security is not deductible to the extent that the taxpayer acquires a substantially identical security within 30 days of the loss sale. The proposal also adds a provision (applicable to all assets covered by the wash sale rule) that identifies related parties whose acquisition of a substantially identical security within 30 days would also implicate the wash sale rule.
The constructive sale rule under Section 1259 provides that if a taxpayer holds appreciated securities and enters into a transaction that substantially reduces the taxpayer’s downside risk for the security (e.g., by selling the security short or entering into certain derivative contracts), the taxpayer will be treated as having sold the appreciated position. As mentioned above, the proposal would broaden this rule to apply to cryptocurrencies.
We continue to monitor these legislative developments and will provide more information as it becomes available. Please contact a Waller tax attorney to discuss specific questions or for more information.