[co-author: Cameron Williamson, Law Clerk]
Former Vice President Joseph Biden has proposed a number of fundamental changes to the tax code over the course of his campaign. If he is elected president and if the Democrats keep control of the House of Representatives and take over the Senate, a number of these provisions are likely to be enacted. In addition to significantly increasing taxes on individuals with income over $400,000, corporate tax rates are likely to increase, an already intricate international tax regime is likely to become more complex and a number of other specific industry-focused provisions are expected to have wide sweeping consequences on taxpayer behavior. Below, we provide a brief description of each of Mr. Biden’s tax-related proposals along with a few observations.
The potential increase in corporate rates would incentivize taxpayers to identify their most appreciated assets and consider transactions to accelerate gain (including potentially at the end of 2020).1 These transactions could include simply accelerating sale transactions already in process, contributions to controlled foreign corporations, hedging transactions for publicly traded securities and entering into so-called “disguised sale” transactions to partnerships. In addition, there would be an incentive to defer deductions until later years when they would be more valuable, including deductions for employee compensation expenses.
While the TCJA’s reduction of the corporate tax rate from 35% to 21% greatly decreased the incentive to structure tax-deferred transactions, Mr. Biden’s proposed rate increase could cause the pendulum to swing back in the other direction, increasing the desirability of tax-deferred reorganizations and other transactions.
Taxpayer incentives are further complicated by Mr. Biden’s proposal to introduce an alternative minimum tax on book income, which is a significantly different tax base than the corporate income tax base. Because alternative minimum taxes like Mr. Biden’s often result in taxpayers not being able to take full advantage of tax preferences purposely enacted by Congress to incentivize specific behaviors (such as an immediate deduction for investment in short-lived property including machinery and equipment), a common criticism of such taxes is that they introduce conflicting policies into the federal tax code, especially when such tax preferences are not taken into account when calculating the alternative minimum tax. Interestingly, though Mr. Biden’s proposed minimum tax is designed to ensure that corporations pay a minimum amount of tax based on book profits, it would allow corporations to take into account foreign tax credits and net operating loss carryovers, which constitute a large part of the difference between book profits and taxable income for many corporations.
U.S.-parented businesses that currently have offshore operations would need to consider whether it is more economical to retain those operations offshore at the cost of the increased GILTI tax or domesticate them to the U.S. and take advantage of the lower effective tax rate of foreign-derived intangible income (potentially subject, however, to the 15% alternative minimum tax discussed above) and the 10% advanceable tax credits. The application of specific provisions to any such domestication (such as base erosion and anti-abuse tax, the deduction for GILTI, and the proposed surtax) remains uncertain. Taxpayers planning in advance for a potential Biden presidency could weigh the benefit of achieving domestication at the current lower rates against taking a “wait and see” approach and potentially benefiting from the 10% advanceable tax credit if they domesticate operations if and when Mr. Biden’s proposals are enacted. In addition, the increase in the corporate tax rate would reduce the benefit of the GILTI high-tax exception, which excludes income subject to a tax rate equal to at least 90% of the corporate tax rate from GILTI. The increase in the corporate rate therefore broadens the GILTI tax base, potentially increasing the effective tax rate on such income for some taxpayers even more than the GILTI rate increase.
Similar to corporate taxpayers, individuals would be incentivized by a Biden victory to accelerate income and gain, and defer deductions. Eliminating the capital gain preference would effectively eliminate certain tax benefits of so-called “promote” or “carried interests” currently available to private equity managers that benefit from long-term capital gain allocations. However, a promote may still be beneficial in that it (i) can be granted and vested on a tax-free basis, (ii) may be used to avoid the 12.4% Social Security tax component of Self-Employed Contributions Act (so-called “SECA”) tax for limited partners, and (iii) is exempt from Sections 409A and 457A governing the deferral of compensation.
Although individual taxpayers may want to accelerate income and gain to mitigate the risk of higher rates under the Biden plan, in the context of employee compensation, this will often conflict with the employer’s desire to defer the deduction of the corresponding employee compensation expense until later years when the deduction would be more valuable. For example, paying annual bonuses for 2020 performance in December 2020 will enable employees to take such bonuses into income in 2020 at lower tax rates but will also accelerate the employer’s corresponding deduction into 2020.
High-net-worth individuals should consider using their remaining gift tax exemption amounts prior to the end of 2020. Currently, the gift and estate tax exemption amount is at an all-time high, $11.58 million per person and $23.16 million per married couple. The TCJA doubled the exemption from prior levels and provided for the enhanced exemption amount to automatically sunset at the end of 2025. If Mr. Biden wins the presidency, the sunset of the enhanced TCJA exemption amount may be accelerated or reduced even further, particularly if Democrats also win control of both chambers of Congress.
In the event of such a victory, taxpayers may also wish to consider triggering capital gains prior to the end of the year, both because capital gains tax rates are likely to rise and because death may no longer be an event that eliminates built-in gain in capital assets.
The Biden proposals create significant incentives for proactive tax planning, especially toward the end of the current tax year. Taxpayers should pay close attention to the outcome of the election and be prepared to act quickly to optimize their tax treatment.
1 Though retroactive tax legislation is rare, in August 1993, a Democratic president and Congress enacted legislation that increased tax rates retroactive to January 1 of that year.