Big tax changes are on the way! President Biden, the House, and the Senate all seem to have their own agenda, but the proposal introduced by the House Ways and Means Committee (the “Proposal”) is a good starting point for predicting what may be in our future.
Corporate and Business Tax Reforms
Corporate Tax Rate: One of the Proposal’s most prominent provisions is a graduated rate structure for the currently flat 21% corporate income tax. The rate would begin at 18% for the first $400,000 of income, followed by 21% for income up to $5 million, and finally a top tax rate of 26.5% on all subsequent income, with phasing out of the graduated rate for those corporations making more than $10 million. Personal service corporations are ineligible for the graduated rates. It should be noted that the Proposal’s highest rate is still less than the 28% President Biden discussed.
Business owners may want to reconsider C corporation status given the increased rate, while taking into account projected income levels and corresponding rate differentials. Pass-through entities, such as LLCs and partnerships, may be a more popular choice if this Proposal is enacted. Perhaps, anticipating the potential reorganizations that may result, the Proposal allows eligible S corporations, or those corporations that were S corporations prior to check-the-box regulations (May 13, 1996), to reorganize as partnerships without triggering tax. This may also be due to the net investment income tax, further detailed below.
GILTI and FDII: The Proposal reduces the deductions for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) to 21.875% and 37.5% respectively, which, when combined with the highest corporate tax rate, would result in rates equal to 16.5625% and 20.7% respectively. Further, GILTI’s application would be on a country-by-country basis. However, if such a deduction exceeds taxable income, the excess shall be added to the net operating loss for the applicable tax year.
Carried Interests: For partnerships, starting in tax years beginning after December 31, 2021, the Proposal extends the holding period of a carried interest from three years to five years in order to be eligible for long term capital gain treatment. However, the three year holding period would continue to remain for real property trades or businesses belonging to taxpayers with an AGI of less than $400,000. The provision also adds particulars for measuring the holding period and heightens regulatory authority to address carry waivers and arranges that avoid the section’s purposes.
1202 Small Business Stock: The Proposal provides that the special 75% and 100% exclusion rate for gains realized from certain qualified small business stock does not apply to taxpayers with an AGI of at least $400,000.
BEAT: There are numerous amendments to base-erosion and anti-abuse tax (BEAT) as applicable to multinational enterprises with average gross receipts in excess of $500 million. The BEAT’s graduated rate would remain at 10% from December 31, 2021, and before January 1, 2024; with an earlier increased rate of 12.5% in taxable years beginning after December 31, 2023, and before January 1, 2026; and finally a rate of 15% to any taxable year beginning after December 31, 2025. Additionally, determining the base-erosion minimum tax amount would include tax credits.
Individual Income Tax and Estate Tax Reforms
Income Tax Rate: The Proposal raises the top marginal individual income tax rate for tax years beginning after December 31, 2021 to 39.6% (a reversion from the prior administration’s decrease), applicable to unmarried individuals with taxable income over $400,000, heads of households with taxable income over $425,000, married individuals filing jointly with taxable income over $450,000, married individuals filing separate returns with taxable income over $225,000, and to estates and trust with taxable income over $12,500.
Capital Gains: For tax years ending following the introduction of the Proposal, the top rate on capital gains would increase from 20% to 25% (less than the 39.6% proposed by Biden). However, there shall be a transition rule that allows the prior 20% to remain applicable to gains and losses for the portion of the tax year prior to the date of introduction.
Net Investment Income Tax: The Proposal expands the Internal Revenue Code (IRC) Sec. 1411 net investment income tax of 3.8% to include all investment income derived in the ordinary course of business for taxpayers with taxable income in excess of $400,000, for single filers and $500,000 for individuals filing jointly, and for trusts and estates. Currently, this tax only applies to individuals and passive income, with business profits being exempt.
Qualified Business Income Deductions: The Proposal sets the qualified business deduction under IRC Sec. 199A for tax years beginning after December 31, 2021 to a maximum of $400,000 for individual returns, $500,000 for joint returns, $250,000 for married individuals filing separate returns, and $10,000 for a trust or estate.
Limitation on Excess Business Losses: The Proposal amends IRC Sec. 461(l) to permanently disallow net business deductions that exceed business income. Taxpayers will be able to carry the disallowed losses forward to the subsequent tax year. This shall apply to tax years beginning after December 31, 2021.
High-income Surcharge: The Proposal adds an additional 3% tax for high income individuals, trusts, and estates with a modified adjusted gross income in excess of $5 million or $2.5 million for married individuals filing separately. In this section, “modified adjusted gross income” shall mean adjusted gross income reduced by deductions allowed for investment interest under IRC Sec. 163(d)). This shall apply to tax years beginning after December 31, 2021. It is likely that this surcharge will apply to capital gains (or capital assets), effectively increasing the capital gains rate for such taxpayers from 20% to 28%. This is an important takeaway for those individuals who plan to sell their business in the foreseeable future. It may very well prove cost effective to complete the transaction or at least enter into a binding contract prior to the December 31, 2021 date.
Unified Credit: The Proposal reverts the unified tax credit that excludes $11.7 million of lifetime gifts from estate and gift taxes to the prior decade’s $5 million per individual, adjusted for inflation. Therefore, when viewed in combination with the increase in capital gains and the additional surcharge, it may be beneficial for an individual to take advantage of the unified tax credit while it still exists. Of course, one should continue to also remember the benefits of a step-up in basis that allow for unrealized capital gains at death to remain exempt from income taxes.
State and Local Tax (SALT) Deduction Limitation: The Proposal was silent on this specific issue, which is surprising given that the SALT deduction is highly significant for some lawmakers. With all the perceived tax hikes on the wealthy, it raises the question as to whether any bill will retain its predecessor’s $10,000 cap on the SALT deduction or allow such deductions to be unlimited. This was a highly contentious issue for both parties even in the Tax Cuts and Job Act’s time, especially for Democrats from states with high income tax rates, such as California and New York. In the popularized remote world post-COVID, it seems to be even more at the forefront, as a result of several taxpayers fleeing highly taxed jurisdictions as more and more companies switch to work from home freedoms. Currently, it does not seem that the bill addresses the issue in either way. Hopefully, more information on this is forthcoming.
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