On September 13, 2021, the House Ways and Means Committee released draft legislation advancing a series of tax proposals (the “Ways and Means Tax Proposals”). This Client Advisory discusses some of these proposals.
- Increase in Individual Income Tax Rates. The top marginal individual income tax rate would be increased to 39.6%, from 37% under current law. The top rate would apply to married individuals filing joint returns with taxable income over $450,000, heads of households with taxable income over $425,000, and unmarried individuals with taxable income over $400,000. The tax rate increase would apply to taxable years beginning after December 31, 2021.
- Increase in Capital Gains Rate. The top long-term capital gains rate would be increased to 25%, from 20% under current law. The higher capital gains tax rate would generally apply to transactions completed after September 13, 2021, subject to a binding contract transition rule.
- Application of Net Investment Income Tax to Trade or Business Income. The 3.8% “Medicare Tax” (also known as the “Net Investment Income Tax”) would be expanded to apply to net investment income derived in the ordinary course of a trade or business provided that the taxpayer’s taxable income is greater than $400,000 in the case of a single filer or $500,000 in the case of a joint filer. The proposed legislation would apply to taxable years beginning after December 31, 2021.
- Surcharge on High-Income Individuals. A 3% surcharge would be imposed in the case of any individual with “modified adjusted gross income” in excess of $5 million (or in excess of $2.5 million in the case of a married individual filing separately). “Modified adjusted gross income” is defined to mean adjusted gross income reduced by the investment interest deduction. This surcharge would apply to taxable years beginning after December 31, 2021.
- Limitation on Deduction of Qualified Business Income. The 20% “qualified business income” deduction allowable under Section 199A of the Internal Revenue Code (the “Code”) would be capped at $500,000 in the case of a joint return, $400,000 for an individual return, and $250,000 for a married individual filing a separate return. This proposed change would apply to taxable years beginning after December 31, 2021.
- Limitation on Excess Business Losses of Non-Corporate Taxpayers. The Code would be amended to permanently disallow a non-corporate taxpayer’s “excess business losses,” as defined in Code Section 461(l).
- Contribution Limit for Individual Plans of High-Income Taxpayers with Large Account Balances. IRA contributions would not be allowed for a taxable year if the total value of an individual’s IRA and defined contribution retirement accounts exceeds $10 million as of the end of the prior year. This limitation would apply to single taxpayers with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000 (all indexed for inflation). This proposal would apply to taxable years beginning after December 31, 2021.
- Increase in Minimum Required Distributions for High-Income Taxpayers with Large Retirement Account Balances. If the aggregate account balance of an individual’s IRA, Roth IRA, and defined contribution retirement accounts exceed $10 million at the end of a taxable year, a minimum distribution would be required for the following year. The minimum distribution would equal 50% of the amount by which the individual’s prior year aggregate IRA and defined contribution account balance exceeds $10 million. The minimum distribution would be required only if the taxpayer’s taxable income exceeds a specified threshold amount (e.g., $450,000 for a joint return). If the combined balance amount in IRAs and defined contribution plans exceeds $20 million, the individual would be required to make a distribution equal to the amount needed to bring the balance down to $20 million. This proposed legislation would apply to taxable years beginning after December 31, 2021.
- Prohibitions of IRA Investments Conditioned on Account Holder’s Status. An IRA would be prohibited from holding any security if the issuer of the security requires the IRA owner to have a minimum level of assets or income or be an “accredited investor.” This proposed legislation would apply to taxable years beginning after December 31, 2021, subject to a two-year transition period for IRAs already holding such investments.
- Prohibition of IRA Investment in Entities in Which the Owner Has a Substantial Investment. An IRA owner would not be allowed to invest IRA assets in a closely held business in which he or she holds a 10% direct or indirect ownership interest or of which he or she is an officer.
- Prohibition of “Back-Door” Roth IRA Strategy. Under current law, (1) contributions to Roth IRAs are subject to income limitations, and (2) under a so-called “back-door” Roth IRA strategy, an individual may make a non-deductible contribution to a traditional IRA and then convert the non-deductible contribution from the traditional IRA to a Roth IRA. This proposal would eliminate the “back-door” Roth strategy for taxpayers with taxable income exceeding $400,000 ($450,000 for joint filers).
Estate and Gift Tax
- Estate and Gift Tax Lifetime Exemption. The estate and gift tax lifetime exemption is $11,700,000 per individual, for 2021. This proposal would return the exemption amount to $5 million per individual (indexed for inflation), which had been in effect prior to the 2017 enactment of the Tax Cuts and Jobs Act. The basic exemption amount in 2022 would be anticipated to be $6,020,000 per individual. This proposed legislation would apply to decedents dying and gifts made after December 31, 2021.
- Valuation Discounts for Certain Transfers of Nonbusiness Assets. This proposal would prohibit valuation discounts (such as marketability discounts and minority interest discounts) for transfer tax purposes in connection with the transfer of “nonbusiness assets,” i.e., passive assets not used in the active conduct of a trade or business. This proposed legislation would apply to transfers after the date of the enactment of legislation.
- Increase in Corporate Tax Rate. The current 21% corporate tax rate (which was reduced from 35% in 2017) would be replaced with a graduated rate structure, with a 26.5% maximum corporate tax rate. The benefit of the graduated rate structure would be phased out for corporations with taxable income exceeding $10 million. Personal service corporations would not be eligible for the graduated rates. The new corporate rate would apply to taxable years beginning after December 31, 2021.
- Limitation on Deduction of Interest by Certain Domestic Corporations Which are Members of an International Financial Reporting Group. If a domestic corporation is part of an “international financial reporting group” and the average annual net interest expense of the domestic corporation exceeds $12 million (over a three-year period), then a portion of its interest expense deduction could be disallowed if the interest expense incurred by the domestic corporation is disproportionately higher (above a stated threshold) than the interest expense incurred by non-U.S. members of the group. Any interest deduction disallowed under this provision would be carried forward for a period of five years. This proposed legislation would apply to taxable years beginning after December 31, 2021.
- Carried Interests. Under current law, to qualify for long-term capital gains treatment with respect to a carried interest, the holding period for the underlying property is generally three years. Under the Ways and Means Tax Proposals, the holding period would generally be extended from three to five years. The three-year holding period would, however, remain in effect for real property trades or businesses and taxpayers with adjusted gross income of less than $400,000. This proposal would apply to taxable years beginning after December 31, 2021.
- Modification to Limitation on Deduction of “Excessive” Compensation. The American Rescue Plan Act of 2021 expanded the number of applicable employees of a publicly traded corporation whose compensation over $1 million is potentially non-deductible under Section 162(m), from five to ten, beginning in tax years after 2026. This proposal would accelerate the effective date of this amendment to Section 162(m) to tax years after December 31, 2021.
- Temporary Rule to Allow Certain S Corporations to Reorganize as Partnerships Without Tax. The proposed legislation would allow an “eligible S corporation,” i.e., any corporation that was an S corporation on May 13, 1996, to reorganize as a partnership without triggering federal tax. To avoid tax, an “eligible S corporation” must completely liquidate and transfer substantially all of its assets and liabilities to a domestic partnership during the two-year period beginning on December 31, 2021.
- Section 1202 – Qualified Small Business Stock. Under current law, an individual may exclude 100% or 75% of gain realized from the sale or exchange of so-called “qualified small business stock” acquired during certain periods, subject to limitations. See Code Section 1202. The proposed legislation would eliminate the 100% and 75% exclusions in the case of individuals with adjusted gross income equal to or exceeding $400,000. The 50% exclusion in Section 1202(a)(1) would, however, remain available. The proposed legislation would apply to sales or exchanges after September 13, 2021, subject to a binding contract exception.
- Wash Sales. Cryptocurrency and other “commodities, currencies and digital assets” would be subject to the wash sale rule, which prevents a taxpayer from claiming a tax loss while retaining an interest in the loss asset, effective for taxable years after December 31, 2021.
- Reduction in GILTI Deduction. The “global intangible low-taxed income” (“GILTI”) tax deduction would be reduced to 37.5%, from 50%, resulting in an effective GILTI tax rate of 16.5625% for a domestic corporation (26.5% with a 37.5% Section 250 deduction).
- Modifications to Foreign Tax Credit Limitations. Foreign tax credit limitations would be determined on a country-by-country basis. Foreign tax carryforwards would be limited to five years, compared with ten years under current law.
- Modification of GILTI Rules. A U.S. shareholder’s GILTI inclusion would be determined separately with respect to each country in which any controlled foreign corporation of the U.S. shareholder is a tax resident. The net deemed tangible income return would be based upon 5% of the “qualified business asset investment” (“QBAI”), reduced from 10% of QBAI under current law.
- Modifications to Foreign Tax Credit Attributable to GILTI. The “deemed paid” foreign tax credit with respect to foreign taxes attributable to GILTI would be increased to 95%, from 80% under current law.
- Foreign-Derived Intangible Income (“FDII”). The tax deduction with respect to FDII would be reduced to 21.875%, resulting in an effective tax rate of 20.7%.
- BEAT. The 2017 Tax Cuts and Jobs Act added to the Code the “base erosion and anti-abuse tax” (the “BEAT”), which imposes an additional tax on certain corporate taxpayers that have had, for the preceding three tax years, average annual gross receipts of at least $500,000,000. The additional tax currently equals ten percent of the taxpayer’s “modified taxable income,” less the taxpayer’s “regular tax liability,” with the regular tax liability being adjusted for certain amounts. The BEAT rate is currently scheduled to increase to 12.5% for tax years beginning after December 31, 2025. Corporate taxpayers that belong to groups containing certain types of financial institutions are subject to a higher rate of tax. The proposed legislation would cause the base BEAT rate to increase to 12.5% for tax years beginning after December 31, 2023 and to 15% for tax years beginning after December 31, 2025. In addition, the scope of modified taxable income would be changed, and the tax amount would be determined taking into account certain credits. The proposed legislation would provide for limited exceptions to the tax. The changes would generally be effective for tax years beginning after December 31, 2021.
What Was Not Included in the Ways and Means Tax Proposals?
- SALT (state and local taxes) relief
- Elimination of basis step-up upon death
- Limitations on like-kind exchanges
- 15% minimum tax on corporations with worldwide book income in excess of $2 billion.
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The Ways and Means Tax Proposals are, of course, subject to change, as Congressional negotiations progress in the coming weeks. It is uncertain whether the Biden administration will ultimately succeed in securing enactment of major tax legislation, in light of razor-thin Democratic majorities in the House and Senate and wide policy differences between moderate and progressive constituencies in the Democratic Party.