President Biden has proposed major changes to the Federal tax laws, some of which are sought to be effective earlier in 2021 (i.e., we are already operating under these changes, if they later become adopted), as compared to the effective date the new tax law changes may be passed by Congress or a later effective date (such as beginning January 1, 2022). The Biden administration proposals must first be approved by Congress. As Congress is now considering these tax law change proposals, the following is a summary of some of the most important:
- Increase the corporate income tax rate from 21% to 28%.
- Impose a minimum 15% corporate income tax on the “book” earnings of large corporations.
- Eliminate incentives for fossil fuels and add/increase incentives for alternative energy.
- Increase the individual income tax rate:
- The proposal would increase the top marginal individual income tax rate to 39.6%. This rate would be applied to taxable income in excess of the 2017 top bracket threshold, adjusted for inflation. In the taxable year 2022, the top marginal tax rate would apply to taxable income over $509,300 for married individuals filing a joint return, $452,700 for unmarried individuals (other than surviving spouses), $481,000 for the head of household filers, and $254,650 for married individuals filing a separate return. After 2022, the thresholds would be indexed for inflation.
- Increase capital gain rates:
- Long-term capital gains and qualified dividends of taxpayers with an adjusted gross income of more than $1 million would be taxed at ordinary income tax rates, with 37% generally being the highest rate (40.8% including the net investment income tax), but only to the extent that the taxpayer’s income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022. A separate proposal would first increase the top ordinary individual income tax rate to 39.6% (43.4% including the net investment income tax).
6. Subject gifts and death transfers to capital gains taxes (at the new rates above):
- The proposal would allow a $1 million per person exclusion from recognition of other unrealized capital gains on property transferred by gift or held at death.
- Also, gain on unrealized appreciation in assets would be recognized by a trust, partnership, or other noncorporate entity that is the owner of the property if that property has not been the subject of a recognition event within the prior 90 years, with such testing period beginning on January 1, 1940. The first possible recognition event for any taxpayer under this provision would thus be December 31, 2030.
- The recipient’s basis in property received by reason of the decedent’s death would be the property’s fair market value at the decedent’s death. The same basic rule would apply to the donee of gifted property to the extent the unrealized gain on that property at the time of the gift was not shielded from being a recognition event by the donor’s $1 million exclusion. However, the donee’s basis in property received by gift during the donor’s life would be the donor’s basis in that property at the time of the gift to the extent that the unrealized gain on that property counted against the donor’s $1 million exclusion from recognition.
- Increase federal employment taxes and “Net Investment Income Tax”:
- The proposal would (i) ensure that all pass-through business income of high-income taxpayers is subject to either the Net Investment Income Tax (“NIIT”) or Self-Employment Contributions Act (“SECA”) tax, (ii) make the application of SECA to partnership and LLC income more consistent for high-income taxpayers, and (iii) apply SECA to the ordinary business income of high-income nonpassive S corporation owners.
- First, the proposal would ensure that all trade or business income of high-income taxpayers is subject to the 3.8% Medicare tax, either through the NIIT or SECA tax. In particular, for taxpayers with adjusted gross income in excess of $400,000, the definition of net investment tax would be amended to include gross income and gain from any trades or businesses that are not otherwise subject to employment taxes.
- Second, limited partners and LLC members who provide services and materially participate in their partnerships and LLCs would be subject to SECA tax on their distributive shares of partnership or LLC income to the extent that this income exceeds certain threshold amounts. The exemptions from SECA tax provided under current law for certain types of partnership income (e.g., rents, dividends, capital gains, and certain retired partner income) would continue to apply to these types of income.
- Third, S corporation owners who materially participate in the trade or business would be subject to SECA taxes on their distributive shares of the business’s income to the extent that this income exceeds certain threshold amounts. The exemptions from SECA tax provided under current law for certain types of S corporation income (e.g., rents, dividends, and capital gains) would continue to apply to these types of income.
- Fourth, to determine the amount of partnership income and S corporation income that would be subject to SECA tax under the proposal, the taxpayer would sum (a) ordinary business income derived from S corporations for which the owner materially participates in the trade or business, and (b) ordinary business income derived from either limited partnership interests or interests in LLCs that are classified as partnerships to the extent a limited partner or LLC member materially participates in its partnership’s or LLC’s trade or business.
- Beginning in 2022, the additional income that would be subject to SECA tax would be the lesser of (i) the potential SECA income, and (ii) the excess over $400,000 of the sum of the potential SECA income, wage income subject to FICA under current law, and 92.35% of self-employment income subject to SECA tax under current law. The $400,000 threshold amount would not be indexed for inflation. Material participation standards would apply to individuals who participate in a business in which they have a direct or indirect ownership interest. Taxpayers are usually considered to materially participate in a business if they are involved in it in a regular, continuous, and substantial way. Often this means they work for the business for at least 500 hours per year. The statutory exception to SECA tax for limited partners would not exempt a limited partner from SECA tax if the limited partner otherwise materially participated.
- Tax “carried” (profits) interests as ordinary income:
- The proposal would generally tax as ordinary income a partner’s share of income on an “Investment Services Partnership Interest” (“ISPI”) in an investment partnership, regardless of the character of the income at the partnership level, if the partner’s taxable income (from all sources) exceeds $400,000. Accordingly, such income would not be eligible for the reduced rates that apply to long-term capital gains. In addition, the proposal would require partners in such investment partnerships to pay self-employment taxes on such income. In order to prevent income derived from labor services from avoiding taxation at ordinary income rates, this proposal assumes that the gain recognized on the sale of an ISPI would generally be taxed as ordinary income, not as capital gain, if the partner is above the income threshold. To ensure more consistent treatment with the sales of other types of businesses, the Administration remains committed to working with Congress to develop mechanisms to assure the proper amount of income recharacterization where the business has goodwill or other assets unrelated to the services of the ISPI holder.
- An ISPI is a profits interest in an investment partnership that is held by a person who provides services to the partnership. A partnership is an investment partnership if substantially all of its assets are investment-type assets (certain securities, real estate, interests in partnerships, commodities, cash or cash equivalents, or derivative contracts with respect to those assets), but only if over half of the partnership’s contributed capital is from partners in whose hands the interests constitute property not held in connection with a trade or business. To the extent (1) the partner who holds an ISPI contributes “invested capital” (which is generally money or other property) to the partnership, and (2) such partner’s invested capital is a qualified capital interest (which generally requires that (a) the partnership allocations to the invested capital be made in the same manner as allocations to other capital interests held by partners who do not hold an ISPI and (b) the allocations to these non-ISPI holders are significant), income attributable to the invested capital would not be recharacterized. Similarly, the portion of any gain recognized on the sale of an ISPI that is attributable to the invested capital would be treated as a capital gain. However, “invested capital” will not include contributed capital that is attributable to the proceeds of any loan or advance made or guaranteed by any partner or the partnership (or any person related to such persons).
- Also, any person who performs services for any entity and holds a “disqualified interest” in the entity is subject to tax at rates applicable to ordinary income on any income or gain received with respect to the interest, if the person’s taxable income (from all sources) exceeds $400,000. A “disqualified interest” is defined as convertible or contingent debt, an option, or any derivative instrument with respect to the entity (but does not include a partnership interest, stock in certain taxable corporations, or stock in an S corporation). This is an anti-abuse rule designed to prevent the avoidance of the property through the use of compensatory arrangements other than partnership interests. Other anti-abuse rules may be necessary.
- Significantly limit Section 1031 “like-kind exchange” deferral:
- The proposal would allow the deferral of gain up to an aggregate amount of $500,000 for each taxpayer ($1 million in the case of married individuals filing a joint return) each year for real property exchanges that are like-kind. Any gains from like-kind exchanges in excess of $500,000 (or $1 million in the case of married individuals filing a joint return) during a taxable year would be recognized by the taxpayer in the year the taxpayer transfers the real property subject to the exchange.
- Substantially increase funding to the IRS for audits and tax enforcement.