Last Friday afternoon, as millions of unsuspecting Americans prepared for the long Memorial Day weekend[ii] – for many, perhaps, their first mask-less holiday celebration in almost 15 months – the Biden Administration released its 114-page “Green Book” for the federal government’s 2022 fiscal year.[iii]
I must confess, I really was looking forward to it. Seriously.[iv] After all, clients are relying upon their tax advisers to understand the Administration’s tax proposals, to assess the likelihood of the proposals’ being enacted, to determine the impact upon their client’s business and estate plans and, based upon the foregoing, to formulate a response if appropriate, or even possible.
I did not expect my weekend read to be as disturbing as it was.
The Green Book
For the uninitiated among you, the Treasury Department releases the “General Explanations of the Administration’s Revenue Proposals” to accompany an administration’s proposed budget for the next fiscal year. This document, also known as the “Green Book,” provides an explanation of an administration’s revenue proposals for that fiscal year.[v]
“Revenue proposals?” you ask. “Taxes,” I reply.
The introduction to the Green Book replays the same message we have heard from then-candidate, and now-President, Biden for months now:
“Income tax rates for those with the highest incomes would increase, and loopholes, such as the carried interest preference and the like-kind real estate preference, would be eliminated for those with the highest incomes. Reformed taxation of capital income would even the tax treatment of labor and capital income and eliminate a loophole that lets substantial capital gains income escape taxation forever . . . Finally, transformative investments in taxpayer compliance would provide the Internal Revenue Service with the resources and information that it needs to build a fairer and more efficient tax administration system.”
Thankfully, the document also sheds light on some of the President’s proposals for which little guidance was previously to be found.
What follows is a discussion of the proposed tax increases and other changes – as described in the Green Book – in which the owners of a closely held business may be most interested, either because they are considering the sale of their business or they are planning for the transfer of the business to the next generation. Most of the discussion will revolve around the taxation of capital gain.[vi]
Although some items were predictable, others came as a surprise because their enactment would represent a sea change, which made me wonder whether these were included among the revenue proposals merely to appease the more “liberal” wing of the Democratic party, or whether they were to be used as a tradeoff during negotiations for what the Administration believes are the more important elements of the budget proposal.
Then there was the possibility that even the unexpected proposals represented a genuinely held belief the enactment of which would receive the President’s and his Party’s utmost support.
Corporate Tax Rate
The proposal would increase the federal income tax rate for C corporations from a flat rate of 21 percent[vii] to 28 percent.
In justifying this tax increase, the Green Book begins by stating: “Raising the corporate income tax rate is an administratively simple way to raise revenue in order to pay for the Administration’s infrastructure proposals and other long-run drivers of spending growth.”[viii]
In other words, it is convenient to do so; small comfort to the owners of a closely held C corporation.
In the case of a corporation that uses the calendar year as its taxable year, the proposed increase would be effective for taxable years beginning after December 31, 2021.
For fiscal years beginning after January 1, 2021, and before January 1, 2022, the increased rate would be pro-rated into effect. Specifically, the tax rate would be equal to (i) 21 percent plus (ii) (a) 7 percent multiplied by (b) the portion of the taxable year that occurs in 2022; in other words, the later in 2021 that a corporation’s fiscal taxable year begins, the greater will be the increase in its tax rate.
For example, a C corporation with a fiscal year that begins on October 1, 2021, and ends on September 30, 2022, would have a tax rate for that year of (i) 21 percent plus (ii) 7 percent * (9/12) = 26.25 percent.
Of course, we already know that some Senate Democrats – Sen. Joe Manchin of West Virginia, in particular – have stated publicly that they will not support a corporate tax rate higher than 25 percent. Moreover, the President has stated publicly that he is willing to move off the 28 percent rate.
There is little doubt whether there will be rate hike. The only question that remains is where the tax rate will end up.
Top Individual Rate
The proposal would increase the top marginal income tax rate for the ordinary income[ix] of individuals from 37 percent to 39.6 percent. This higher rate was in effect through the end of 2017, was reduced by the TCJA, and is scheduled to be reinstated in 2026.
Thus, the budget proposal would merely accelerate by four years an already scheduled tax increase by making it effective for taxable years beginning after December 31, 2021.[x]
The 39.6 percent rate would be applied to taxable income in excess of the 2017 top bracket threshold, adjusted for inflation. Thus, in taxable year 2022, the top marginal tax rate would apply to taxable income over $509,300 for married individuals filing a joint return, and over $452,700 for unmarried individuals.
This should be compared to the brackets at which the 37 percent rate applies during 2021: over $628,300 for married individuals filing a joint return, and over $523,600 for unmarried individuals.
In other words, the higher 39.6 percent rate will apply at a lower bracket than today’ s 37 percent rate, thereby capturing a greater number of taxpayers, and subjecting more of a higher-earning individual’s taxable income to the higher rate – a double whammy.
Among the items of income to which the higher rate will apply, for example, is compensation for services, ordinary business income,[xi] interest on loans, net rental income, royalties, depreciation recapture, and gain from the sale or exchange of property between certain related parties.[xii]
In contrast to the corporate tax, no congressional champion has taken a stand in defense of a lower individual income tax rate. Therefore, a taxpayer who expects to receive a large bonus, for example, in 2022, may want to see whether its payment can be accelerated into 2021. Similarly, the same taxpayer may want to consider deferring a large charitable contribution, for example, into 2022.
Individuals’ Capital Gains
Perhaps the most significant feature among the revenue generators included in the Administration’s 2022 Budget addresses the question of capital gains.
After reciting how the preferential rates on long-term capital gains and qualified dividends[xiii] have disproportionately benefitted higher income individuals, and have increased the economic disparities among individual taxpayers, the Green Book proposes that the long-term capital gains and qualified dividends (the “ LTCG”) of taxpayers with adjusted gross income (“AGI”) of more than $1 million for a taxable year be taxed at the ordinary income tax rates, with 39.6 percent generally being the highest rate (or 43.4 percent, including the 3.8 percent net investment income surtax[xiv]), but only to the extent that the taxpayer’s income for the taxable year exceeds $1 million ($500,000 for married individuals filing separately); this threshold amount would be indexed for inflation after 2022.
For example, the LTCG of a married taxpayer filing a joint return with AGI of $1.1 million (i.e., greater than $1 million) for the taxable year would be subject to the increased rate.
If the amount of this excess – $100,000 in our example – is greater than the taxpayer’s LTCG, then all such capital gain will be taxed at the ordinary income rate. That would be the case where the taxpayer has compensation income of $1.05 million and LTCG of $50,000; the entire $50,000 of LTCG would be taxable at the ordinary rate.
If the amount of the excess is less than the taxpayer’s LTCG, then only that portion of the LTCG equal to the excess will be taxed at ordinary rates; the remaining LTCG would be taxed at the current preferential rate. In our example, if the taxpayer’s LTCG is $200,000, then $100,000 of the LTCG would be taxed at the current preferential tax rate and $100,000 at the ordinary income tax rate.
This proposal would be effective for gains required to be recognized after the date of
enactment announcement. (No, you’re not imagining this. It’s not a typo. They intended to say “announcement.”) The Administration announced this proposal in April of 2021.
Therefore, gain recognized after such date will be subject to the higher rate regardless of whether the sale from which the gain arose occurred prior to the date of announcement; for example, the post-announcement “required recognition event” may be a payment on an installment obligation, the release of funds from an escrow, or the payment of an earn out.
Similarly, the gain from a sale that occurs after the announcement date but before the date of enactment will be subject to the revised rate.
Thus, the gain from sales and exchanges occurring after such date would be subject to the higher rate of tax.
Likewise, the recognition of any gain from a sale being reported under the installment method would be subject to the rate hike if payment is received after the date of enactment, notwithstanding that the sale may have occurred before such date.
Forced Recognition of LTCG
The Administration recognizes that merely increasing the rate applicable to long-term capital gains will not ensure the taxation of such gain. The imposition of the tax on the gain inherent in a property requires that the gain first be recognized – it requires an actual or deemed sale or exchange of the property.
What if the taxpayer decided to gift or bequeath an appreciating asset (or pool of assets) to family members or to a trust for their benefit? The economic benefit associated with the asset has been shifted to the recipient, but so has the economic risk.[xv] Until the asset is sold, the recipient merely steps into the donor’s shoes.
What if the assets were used to secure indebtedness incurred by the trust, the proceeds of which are used by the beneficiaries?[xvi] The receipt of the loan proceeds is not treated as income to the borrower because there has been no accretion in value to the borrower – the loan must be repaid.
The Administration, however, proposes to circumvent these economic truths, or inconveniences, by proposing to expand the types of events that trigger the recognition of gain.
Specifically, the Green Book proposes that the transfer of appreciated property by gift during the life of the taxpayer, or the transfer of such property upon the death of the taxpayer, be treated as a realization event, as a deemed sale.[xvii]
Under the proposal, the donor (i.e., the individual making the gift) or the deceased owner (making the bequest, devise, or other testamentary transfer) of an appreciated asset would realize a capital gain at the time of the transfer.
This would include a transfer to an irrevocable trust, regardless of whether the trust is treated as a grantor trust.[xviii]
For a donor, the amount of the gain realized would be equal to the excess of the asset’s fair market value on the date of the gift over the donor’s adjusted basis in that asset. For a decedent, the amount of gain would be the excess of the asset’s fair market value on the decedent’s date of death over the decedent’s basis in that asset.[xix] That gain would be treated as taxable income to the decedent on the Federal gift or estate tax return or on a separate capital gains return.[xx]
Fair Market Value
The fair market value of an asset, for purposes of this deemed sale rule, would be determined using the methodologies normally used for gift or estate tax purposes; i.e., the standard of the hypothetical willing buyer and willing seller.[xxi] However, the value of a transferred “partial interest” (which presumably includes a minority interest in a business entity) would be its proportional share of the fair market value of the entire property; in other words, its liquidation value, with no discounts for lack of control or lack of marketability.
As if the foregoing was not audacious enough, the Administration is also proposing that gain on unrealized appreciation be recognized by a trust, partnership, or “other noncorporate entity” that is the owner of property that has not been the subject of a recognition event within the prior 90 years.[xxii]
Although it seems unlikely that a trust will have held shares of stock in a single corporation for over 90 years, it is quite possible that a trust will have retained ownership of rental real property, or of an interest in a partnership or other business entity that owns such real property, for that length of time.
According to the Green Book, the first 90-year period[xxiii] to which this deemed sale rule will apply is the period beginning on January 1, 1940.[xxiv] Therefore, the first possible deemed recognition event for any taxpayer under this provision would be December 31, 2030; if a trust has held a property throughout that period, the trust will be treated as having sold the property at the end of such period.[xxv]
In the case of a revocable trust, the deemed grantor-owner would recognize gain on the unrealized appreciation in any asset distributed from the trust to any person other than the grantor or the grantor’s U.S. spouse.[xxvi]
All the unrealized appreciation on assets of a revocable grantor trust would be realized at the deemed owner’s death, or at any other time when the trust becomes irrevocable – i.e., when the transfer is completed.[xxvii]
The foregoing proposal would be effective for gains on property transferred by gift, and on property owned at death by decedents dying, after December 31, 2021, and on certain property owned by trusts, partnerships, and other non-corporate entities on January 1, 2022.
Exclusions from Deemed Sale
Not every gratuitous lifetime or testamentary transfer – i.e., one made without consideration – would be treated as a taxable event under the Administration’s proposals; there are certain exclusions.
Spouses and Charities
The transfer by a decedent to a U.S. spouse (citizen or resident)[xxviii] would carry over the basis of the decedent, and capital gain would not be recognized until the surviving spouse disposes of the asset or dies, at which point the deemed sale rules described above would apply.
A transfer of appreciated property to charity – for example, a contribution of real property or of S corporation stock to a public charity – would not generate a taxable capital gain.[xxix]
The taxpayer’s transfer of appreciated assets to a split-interest trust (for example, a charitable remainder trust or a charitable lead trust) would generate a taxable capital gain, based upon the actuarially determined value of the noncharitable interest; in other words, an exclusion would be allowed for the charity’s share of the gain inherent in the asset based on the charity’s share of the value transferred as determined for gift or estate tax purposes.
The exclusion under current law for capital gain on certain small business stock[xxx] would also apply; meaning that the transfer of qualifying C corporation stock by gift or at death would not be treated as a sale of such stock pursuant to the above rules.
Rather, in accordance with Section 1202 of the Code, the transferee of such stock will continue to be treated as having acquired the stock in the same manner as the transferor, and as having held the stock during any continuous period immediately preceding the transfer during which it was held by the transferor.[xxxi]
In addition to the above exclusions, the Administration’s budget 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. This appears to be a lifetime exclusion – contrast it with the $1 million annual AGI threshold for taxing capital gains at ordinary rates, described above.
The per-person exclusion would be indexed for inflation after 2022 and would be portable to the decedent’s surviving spouse under the same rules that apply to portability for estate and gift tax purposes (thus making the exclusion effectively $2 million per married couple).
Basis Following the “Sale”
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; i.e., the amount against which the gain on the deemed sale was measured (a “cost” basis, if you will).
The same basis 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.
The Family Business
Notwithstanding the foregoing deemed sale rule, the tax on the appreciation of certain family-owned and -operated businesses would not be due until the interest in the business is sold or the business ceases to be family-owned and operated.
Although the Green Book is short on details, it will likely be the case that, in order to qualify, the business will have to be engaged in an active trade or business at the time of the transfer; the management of investment assets will probably not suffice.
In addition, the proposal takes a page out of the rules for the deferred payment of estate tax by allowing a 15-year fixed-rate payment plan for the tax on appreciated assets that are transferred at death, except to the extent the tax is attributable to liquid assets.[xxxii]
The IRS would be authorized to require collateral security from the taxpayer at any time it determines there is a reasonable need for security to continue the deferred payment of the tax.
Finally, the proposal would allow a deduction for the cost of appraising appreciated assets in connection with the tax.[xxxiii]
Like Kind Exchanges[xxxiv]
The proposal would allow the deferral of gain up to an aggregate amount of $500,000 for each individual taxpayer ($1 million in the case of married individuals filing a joint return) each year for real property exchanges that are like kind.
Thus, the $500,000 cap is an annual limit; it is not a transactional limit.
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, regardless of whether cash or other “boot” was received in the exchange.
It is not clear at this point whether the Administration is contemplating anti-abuse rules that would attribute gain between certain related persons to prevent the use of multiple caps.
Of course, any pre-exchange transfers made by a taxpayer with a view toward securing the use of multiple caps may be taxable under the deemed sale rules described above.
The proposal would be effective for exchanges completed in taxable years beginning after December 31, 2021.
To be Continued
Later this week, we will review the Administration’s proposals regarding the tax treatment of profits interests and its plan to expand the reach of the FICA tax and of the net investment income surtax.
[i] “Extra, extra! Read all about it!” is what newsies would shout to grab the attention of potential buyers/readers when breaking news was reported in the “extra” addition of a daily paper.
[ii] A press release at the start of a holiday weekend – or on any Friday for that matter – is great if your goal is to avoid anyone’ s taking notice. https://expresswriters.com/strategically-planning-release-press-release/ .
[iii] The federal government’s 2022 fiscal year runs from October 1, 2021 through September 30, 2022.
[iv] Remember the 1979 Rob Reiner-directed movie, The Jerk? With Steve Martin as Navin, and Jackie Mason as Harry.
Navin: The new phone book’s here! The new phone book’s here!
Harry: Boy, I wish I could get that excited about nothing.
Navin: Nothing? Are you kidding? Page 73 – Johnson, Navin R.! I’ m somebody now! Millions of people look at this book every day! This is the kind of spontaneous publicity – your name in print – that makes people. I’m in print! Things are going to start happening to me now.
[v] The Trump Administration decided not to issue Green Books.
[vi] We will consider the tax treatment of profits interests and the expansion of the net investment income surtax and of the FICA tax later this week.
[vii] The flat rate of 21% was enacted by the Tax Cuts and Jobs Act of 2017 (the “TCJA”) (P.L. 115-97). It replaced the graduated rate system which provided a maximum corporate rate of 35%.
[viii] It also adds:
“Furthermore, a corporate tax rate increase can increase the progressivity of the tax system and help reduce income inequality. Additionally, a significant share of the effects of the corporate tax increase would be borne by foreign investors. Therefore, some of the revenue raised by this proposal would result in no additional federal income tax burden to U.S. persons. Also, the majority of U.S. equity income is untaxed by the U.S. government at the individual level, so the corporate tax is a primary mechanism for taxing such capital income.”
[ix] For example, compensation for services, interest on loans, rent or royalties for the use of property, depreciation recapture, gain from the sale of certain related party transactions (see, for example, IRC Sec. 1239), etc.
[x] Individual taxpayers use the calendar year as their taxable year.
[xi] Including one’s share of such income from an S corporation or tax partnership.
[xii] See, for example, IRC Sec. 1239 and Sec. 707(b).
[xiii] IRC Sec. 1(h)(11).
[xiv] IRC Sec. 1411.
[xv] The benefits and burdens of ownership. A gift of an interest in Manhattan real estate seemed like a sure thing until March 2020, when many tenants stopped paying their rent, and as other spaces remained vacant.
[xvi] Think in terms of refinancing a real property to withdraw the equity therefrom.
[xvii] Mind you, we are not talking about a part-sale, part-gift resulting from the transfer of encumbered property; nor are we considering the transfer of a partnership interest to which partnership debt has been allocated under IRC Sec. 752.
[xviii] IRC Sec. 671 et seq. other than Sec. 676 (the grantor’s power to revoke any transfer to the trust).
[xix] Without a basis step-up at death, of course.
[xx] The use of capital losses and carry-forwards from transfers at death would be allowed against capital gains income and up to $3,000 of ordinary income on the decedent’s final income tax return, and the tax imposed on gains deemed realized at death would be deductible on the estate tax return of the decedent’s estate (if any).
“If any” – in other words, a decedent’s estate may be less than the estate tax exemption, but the estate may still be subject to this capital gain tax.
[xxi] The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Reg. Sec. 20.2031-1(b).
[xxii] Between three and four generations under IRC Sec. 2651.
[xxiii] This proposal echoes one made in President Obama’s 2014 budget, which provided that, on the 90th anniversary of a trust’s creation, the GST exemption allocated to the trust would terminate and cease to have any effect on distributions from the trust. This result would be achieved by increasing the trust’s inclusion ratio to one, thereby rendering the entire trust subject to GST tax. IRC Sec. 2642.
[xxiv] Why did the Administration select this date?
[xxv] Query how accurate the taxpayer’s basis information will be.
[xxvi] The transfer to a U.S. spouse is covered by IRC Sec. 1041, which provides that no gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of) their spouse who is a U.S. c1tizen or resident.
Of course, if the distribution from the trust was made to a third party in discharge of an obligation of the grantor, then grantor would recognize gain as if the asset transferred from the trust had been sold by the grantor.
[xxvii] The 2014 budget proposed by Mr. Obama also addressed grantor trusts; specifically, trusts to which the grantor sold property for consideration and, thereby, avoided making a taxable gift for purposes of the gift tax. Upon the grantor-deemed owner’s death, the portion of the trust attributable to the property received in that sale transaction (including all its retained income and appreciation) would be subject to estate tax as part of the grantor’s gross estate. In addition, such portion would be subject to gift tax during the grantor-deemed owner’s life when the grantor ceased to be treated as the owner for tax purposes. Any distribution from the trust to another person would also be treated as a gift by the deemed owner. The transfer tax would be payable from the trust.
[xxviii] IRC Sec. 1041.
[xxix] Of course, there are other issues to be considered in each of these cases. First, there is the charitable contribution deduction and its affect upon the overall “cost” of the transfer. See IRC Sec. 170.
The donees have their own considerations; for example, should the charity accept title to the real property directly or though an LLC? As for the S corporation stock, how will the charity handle the UBIT attributable to its shares?
[xxx] IRC Sec. 1202. See my article on the internet at https://www.taxlawforchb.com/2020/11/the-loss-of-the-favorable-capital-gain-rate-the-exclusion-of-gain-under-section-1202-and-the-incorporation-of-the-partnership/ .
[xxxi] IRC Sec. 1202(h).
[xxxii] See IRC Sec. 6166.
[xxxiii] IRC Sec. 2053. The IRS would be granted broad regulatory authority to provide implementing rules for the foregoing.
[xxxiv] IRC Sec. 1031.