For corporate taxpayers, Biden’s tax plan would increase the tax rate to a flat 28%, the mid-point between the 21% flat rate currently in effect and the 35% maximum pre-TCJA rate. To ensure that large profitable companies pay some level of tax, Biden proposes a 15% minimum tax on book income for companies reporting $100 million or more. In addition, Biden proposes to double the tax rate applied to the global intangible low-taxed income (GILTI) of U.S. companies with foreign operations from 10.5% to 21%, likely prompting affected companies to restructure their operations to mitigate its impact. Although it is not clear, the GILTI tax change may be implemented by reducing the GILTI deduction, which is currently 50%, to 25%.
Also, under consideration is a recent proposal for a 10% penalty surtax on profits from goods that are manufactured or produced abroad, but sold in the U.S. market. The new surtax results in a 30.8% corporate tax rate, which consists of the increased 28% corporate tax rate and the resulting penalty of 2.8%. To provide other incentives to U.S. companies making investments in domestic manufacturing and to help revitalize closed U.S. facilities, Biden proposes a 10% advanceable tax credit. The new Biden policies generally seek to roll back parts of the TCJA’s foreign taxation provisions to discourage overseas manufacturing if the same work can be done domestically by U.S. workers.
The corporate income tax rate reduction under the TCJA induced many pass-through businesses (S corporations, partnerships, and LLCs taxed as partnerships) to migrate to C corporation status, as the spread between the corporate tax rate of 21% and the TCJA top marginal individual tax rate of 37% (for pass-through businesses ineligible for the 20% deduction) became an eye opening 16%. The Biden plan would narrow that spread to 11.6% (39.6%-28%) when coupled with the restoration of the top individual tax rate to 39.6% as under pre-TCJA law, which is still a meaningful difference.
Converting into a C corporation made sense for companies that were reinvesting after tax profits in pursuit of growth, as the second layer of tax that applies to dividends at the shareholder level would not be incurred. But for a C corporation that regularly distributes its earnings, the effective corporate/shareholder tax rate is currently 39.8% (21% + (1-.21)*23.8%). The Biden plan would increase that to 45.1% (28% + (1-.28)*23.8%), or 59.2% (28% + (1-.28)*43.4%) for high income taxpayers by making taxpayers with income over $1 million ineligible for the favorable tax rate on long-term capital gains and qualified dividends.
Pass-Through Businesses and Schedule C Filers
On the other hand, pass-through entity owners and schedule C filers presently pay a top federal income tax rate on business income of 37% or 29.6% to the extent the earnings qualify for the 20% pass-through deduction. The Biden plan increases the top individual tax rate to 39.6% and, for taxpayers with income over $400,000, repeals the pass-through deduction via a phase-out formula.
Currently, for business income, other than income from rental real estate which is expressly exempt, active pass-through owners and Schedule C filers pay a self-employment tax of 12.4% on business income up to $137,700 and Medicare tax of 2.9% (plus the .9% surcharge on income above $200,000) on all such income without any cap. When combined with the proposed repeal of the self-employment income cap on income in excess of $400,000, the top marginal overall federal tax rate for Schedule C filers and active pass-through business owners could be as high as 53.0% (39.6% top income tax rate + 2.9% Medicare tax rate + .9% additional Medicare tax + 12.4% self-employment tax, less the benefit of the 50% of self-employment tax deduction of 2.8%, or 15.3% * 92.35% * 50% * 39.6%). Businesses with employees earning wages in excess of $400,000 annually will shoulder 6.2% of the additional 12.4% social security tax assessed on these wages as well.
A perennially popular strategy for mitigating self-employment and Medicare taxes has been conducting business through an S corporation, because unlike partnerships and LLCs, S corporation pass-through income is exempt from these taxes. Although an S corporation is required to pay a reasonable salary to its owners that are involved in the business (which is subject to social security and Medicare tax), depending on the context, this often is interpreted as a minimum amount, particularly where significant capital and/or other labor is involved. Income in excess of that is exempt from these additional taxes. While S corporations are generally considered inferior to LLCs as an entity choice due to their comparative inflexibility (e.g., fixed income and loss allocations), under the right circumstances, it could be a wise choice.
Like S corporations, income of a limited partner in a limited partnership is not subject to self-employment tax on the partner’s share of partnership income irrespective of the level of participation in the business, provided that the income is not a guaranteed payment for services performed. If the limited partner is passive, then the pass-through income would be subject to the 3.8% additional tax on net investment income. However, under most modern state limited partnership statutes, a limited partner can be active in the business without shedding liability protection. Thus, in the right circumstances, the needle can be thread between self-employment and Medicare taxes and the net investment income tax by using a limited partnership. While limited partnerships are more flexible than S corporations, they are more cumbersome to form and maintain since to limit general partner liability for entity level liabilities, it is a standard practice to have a corporation or LLC act as the general partner. A limited partnership must have at least one general partner. There is no guarantee, however, that these legal loopholes would not be slammed shut in implementing legislation. Absent that happening, these strategies could be quite useful in the event such legislation is passed.
Pass-through owners with total income over $200,000 and that are passive with respect to the pass-through businesses will pay, in addition to regular income tax, the 3.8% net investment income tax on their share of pass-through income. Under current law, such taxpayers pay a maximum overall top federal tax rate of 40.8% (37% + 3.8%) on pass-through income, or 33.4% (37%*(1-.20) + 3.8%) to the extent eligible for the 20% pass-through deduction. Under the Biden plan, these situated taxpayers will pay a top marginal federal tax rate of 43.4% (39.6% + 3.8%).
The foregoing discussion has focused on business income, which is ordinary as distinguished from long-term capital gain. Currently, long-term capital gains tax rates for individual taxpayers range from 0 to 20%, depending on one’s overall income level—making the top marginal tax rate on this species of income 23.8% when combined with the net investment income tax. For taxpayers with income in excess of $1 million, the Biden plan would tax long-term capital gain as ordinary income subject to the top marginal tax rate, making the total top marginal federal tax rate 43.4% (39.6% + 3.8%). Gain from the sale of stock or LLC interests in private businesses, as well as the sale of business property, including real estate, often qualifies under current law as long-term capital gain if held for more than one year. Taxpayers with sales transactions pending or under consideration should try and expedite them for a 2020 closing to be sure this benefit is not lost. Also, strategies such as installment sales may prove useful in certain contexts.
Real Estate Related Provisions
The real estate industry stands to lose some long-standing tax advantages under a Biden tax bill. By far the provision most dear to the industry is the beloved tax-free exchange under section 1031. The TCJA narrowed the availability of section 1031 to only real estate, where previously it was available for tangible personal property, including business airplanes and investment art. The Biden plan looks to eliminate real estate from this benefit, affecting its full repeal, although some have reported that this repeal would be limited to taxpayers with income over $400,000.
A fixture in the Internal Revenue Code since 1921, section 1031 has been a standard tax deferral strategy in real estate dispositions, supported by a cottage industry of knowledge-based service providers. It is a primary factor in the liquidity of the real estate market. The aggregate amount of deferred gain currently inherent in U.S. real estate assets from section 1031 transactions is likely a significant number. The Joint Committee on Taxation has estimated the tax cost to the Treasury from 2016-2020 at $90 billion. A 20% capital gains tax rate suggests that the deferred gain just for those years equates to some $450 billion. If coupled with the repeal of the step-up in basis at death, discussed below, and elimination of favorable capital gains rates, the current relative liquidity enjoyed by real estate is bound to be impacted, potentially affecting prices heavily.
Other techniques, such as complex partnership mixing bowl transactions, would likely be popular as section 1031 surrogates. In addition, the cash-out nonrecourse refinancing, a standard real estate liquidity strategy for generations, and the tax law provisions supporting its tax-free status, do not appear to be at risk under a Biden tax plan. Already popular long-term ground and master lease transactions would become more so in a world without section 1031.
Other real estate related items that may be in a Biden tax plan include lengthening the recovery period for residential rental property, currently 27.5 years, to equal that of the 39 years applicable to commercial property and repealing the $25,000 special loss allowance for certain active rental real estate owners.
Other Provisions Affecting Business Owners
The TCJA created a deduction equal to 20% of certain business income, including rental real estate income, for schedule C filers and pass-through entity owners. The deduction is limited by certain wage and property basis caps for higher income taxpayers. This deduction is scheduled to expire for tax years beginning after December 31, 2025. A Trump plan would make this deduction permanent. The Biden plan phases this deduction out for taxpayers earning more than $400,000. When coupled with the increase in the top marginal tax rate to 39.6%, a taxpayer previously eligible for this deduction would see its overall top marginal federal income tax rate increase from 29.6% to 39.6%.
A key revenue raising feature of the Biden tax plan is the repeal in the step-up in basis to fair market value of assets held by a decedent at death. Currently, it is unclear as to whether the proposed repeal would be implemented through an income tax imposed on unrealized appreciation at death or by way of the decedent’s heirs inheriting the decedent’s tax basis along with the property. Under a Biden tax bill, an income tax imposed at death could cause extreme liquidity issues, particularly for an estate subject to estate taxes and comprised of nonliquid assets. Moreover, a concurrent repeal of the capital gains preference for high income taxpayers would further exacerbate liquidity concerns. This is not a scenario the vast majority of estate planners are likely to have considered in their planning.
If this policy is effectuated by having the decedent’s heirs inherit the decedent’s tax basis in the inherited property, the impact on estate liquidity would be less severe, but the strategy of selling assets to generate funds for estate taxes would create a circularity problem. Existing provisions of tax law allowing for the deferral of estate taxes on estates with closely held business interests and/or in hardship situations would take on heightened importance.
The phenomenon of business real estate securing nonrecourse debt exceeding the owner’s tax basis (colloquially, “negative basis” or “negative capital”), often in large amount, is as common as any in the real estate industry. Abetted by the tax law and capital markets that rely on its quality as collateral, removing equity from the property on a tax-free basis through an upsized nonrecourse refinancing in lieu of a taxable sale or section 1031 exchange is a tried and true alternative. This negative basis is, under current law, eliminated on death due to the basis adjustment to fair market value. Most business real estate owners understand this key point and it has been a significant factor in their decision making in dealing with their properties and in their estate plans. As with deferred gains from section 1031 exchanges, the magnitude of the negative basis condition across the real estate industry is undoubtedly enormous. The repeal of step-up in basis at death will certainly throw an unexpected wrinkle into estate plans throughout the real estate community, contributing to liquidity problems as well as reliance on a continually narrowing field of available tax deferral strategies.
The foregoing analysis covers the business-related themes that have been highlighted by the campaigns, think tanks, and various media sources. Potential tax legislation affecting businesses is by no means limited to these areas and could be more expansive or narrow in scope once implemented.