On Monday, September 13, 2021, the House Ways and Means Committee released several markups of proposed legislation (the “House Tax Proposals”) intended to pay for various proposed spending initiatives. Importantly, the House Tax Proposals are not entirely consistent with the “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals” (the “Green Book”) released by the U.S. Department of Treasury on May 30, 2021, and in at least one respect results in an unforgivable whip-sawing of taxpayers.
The purpose of this Dykema Tax Alert is to briefly summarize the House Tax Proposals as they affect businesses and their owners.
Capital Gains Rate
The Green Book proposed to tax long-term capital gains and qualified dividends of taxpayers with adjusted gross income of more than $1 million at ordinary income tax rates (as discussed below, proposed to increase to a top rate of 39.6%). As we previously noted, the Green Book proposal was intended to be effective for capital gains required to be recognized after the date of announcement, which is generally understood to be April 28, 2021.
The House Tax Proposals increase the top long-term capital gains rate to 25%, but only for capital gains recognized after September 13, 2021. Although the proposal includes a transition rule for written binding contracts entered into before September 13, 2021, the government appears to be playing a game of gotcha with taxpayers.
The Green Book made it clear that taxpayers could not lock in the current 20% capital gains rate by disposing of capital assets after April 28, 2021. Now, the government is saying that taxpayers should have ignored the White House’s cutoff date, but, nonetheless, it is again too late to capture the 20% capital gains rate on incomplete dispositions of capital assets (with the exception of the transition rule).
There is of course no proposed transition rule for transactions economically occurring on or prior to September 13, but which are treated as occurring on December 31 for income tax purposes. For example, a distribution of money by a partnership in excess of basis is generally treated as capital gain. However, even if the distribution is made on September 13, it is treated as occurring on December 31 for income tax purposes. The House Tax Proposal does not seem to contemplate the complications associated with the government’s whip-saw of taxpayers who accepted the Biden Administration’s word that, after April 28, it was too late to benefit from the current 20% capital gains rate on dispositions of capital assets.
Ordinary Income Tax Rate Changes
Consistent with the Green Book, the House Tax Proposals increase the top individual income tax rate beginning in 2022 to 39.6% for married taxpayers filing jointly with taxable income over $450,000, unmarried taxpayers with taxable income over $400,000, and estate and trusts with taxable income over $12,500.
The House Tax Proposals include a new surcharge beginning in 2022 on high income individuals, estates and trusts. The surcharge is equal to 3% of modified adjusted gross income in excess of $5,000,000 for married individuals filing jointly, $2,500,000 for a married individual filing separately, or $100,000 in the case of an estate or trust (excluding charitable trusts).
For individuals, modified adjusted gross income means adjusted gross income reduced by any deduction (not taken into account in determining adjusted gross income) allowed for investment interest.
Obviously, when added to either the new top individual rate (39.6%) or the new top long-term capital gains rate (25%), the tax burden on top earners is materially increased.
Section 199A Ceiling
Starting with the 2022 tax year, the House Tax Proposals limit the deduction for qualified business income for high earners. Under the proposal, the maximum allowable deduction is $400,000 for single filers and $500,000 for married individuals filing jointly. The limit for estates and trusts is $10,000.
Extended Reach of Net Investment Income Tax
Under the House Tax Proposals, and starting with the 2022 tax year, individuals with modified adjusted gross income in excess of $400,000 (unmarried individuals) or $500,000 (married individuals filing jointly) will become subject to the net investment income tax of 3.8%. This means that active shareholder/employees of S corporations with modified adjusted gross income in excess of the threshold amount will no longer be able to avoid the net investment income tax. Net investment income tax is calculated by subtracting eligible deductions fromgrossinvestment income earned in the taxable year, including profits realized upon sale, dividends, interest payments, and income from rental properties. If a taxpayer’s modified adjusted gross income exceeds the thresholds, the 3.8% net investment income tax is applied to the lesser of the net investment income or the amount by which the modified adjusted gross income exceeds the income thresholds.
Section 1202 Stock
Section 1202 of the Internal Revenue Code has generally allowed certain noncorporate taxpayers to avoid tax on up to $10 million of gain on the disposition of certain C corporation stock. Under the House Tax Proposals, the special 75% and 100% exclusion rates applicable to Section 1202 stock will not apply to taxpayers with adjusted gross income equal to or exceeding $400,000.
As in the case of the new capital gains rate, the change is effective for sales and exchanges on or after September 13, 2021, with an exception for written binding contracts in effect on September 12, 2021.
Section 1259 of the Internal Revenue Code provides that, if there is a constructive sale of an “appreciated financial position,” the taxpayer shall recognize gain as if such position were sold, assigned or otherwise terminated at fair market value on the date of such constructive sale. The term “appreciated financial position” means any position with respect to any stock, debt instrument, or partnership interest if there would be gain were such position sold, assigned, or otherwise terminated at its fair market value. A taxpayer is treated as having made a constructive sale of an appreciated financial position if the taxpayer enters into certain designated financial transactions, e.g., enters into a short sale of the same or substantially identical property.
Under the House Tax Proposals, the definition of “appreciated financial position” is expanded to include “digital assets.” The term “digital asset” means any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology. This change applies to constructive sales occurring after the date the proposal is enacted into law.
The tax reform legislation enacted in late 2017, formerly known as the Tax Cuts and Jobs Act (Pub. L. No. 115-97, “TCJA”) added Section 1061 of the Internal Revenue Code. That section impacts the tax treatment accorded to a special type of partnership profits interest referred to as an applicable partnership interest.
If a profits interest is an applicable partnership interest, the gain or loss reported by its holder is subject to a special holding period. Specifically, gains passed through to a service partner from the sale of a partnership’s portfolio investments, in addition to gains related to the disposition of the applicable partnership interest itself, qualify for long-term capital gain treatment only if held by the partnership or partner, respectively, for more than three years. The new holding period requirement for applicable partnership interests contrasts with the general rules under which a capital asset qualifies for long-term capital gain treatment if held for more than one year.
Under the House Tax Proposals, beginning with the 2022 tax year, the holding period for an applicable partnership interest is extended from three years to five years.
Provisions in the House Tax Proposals but not in the Green Book
Limitations on Excess Business Losses of Noncorporate Taxpayers
The TCJA amended Section 461 of the Internal Revenue Code by including subsection (l) which disallows excess business losses of noncorporate taxpayers for losses in excess of $500,000 for joint filers and $250,000 for individuals. Any disallowed losses may be carried forward to the following tax year as a net operating loss. The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) provided relief for taxpayers for the 2018, 2019, and 2020 tax years by eliminating the excess business loss limitation for those years. Under the House Tax Proposals, Section 461(l) will be amended to permanently disallow noncorporate taxpayer’s excess business losses; however, the losses can be carried forward to the next succeeding tax year as a deduction. This provision will be retroactive to tax years beginning after December 31, 2020.
Modifications to Treatment of Certain Losses
Section 165(g) of the Internal Revenue Code provides that if a security treated as a capital asset becomes worthless during the taxable year, the security shall be treated as a loss from the sale or exchange of a capital asset on the last day of the taxable year. Under the House Tax Proposals, Section 165(g) will be amended to provide that the security will be treated as a loss from the sale or exchange of a capital asset “at the time of the identifiable event establishing worthlessness.” Thus, the House Tax Proposals may limit the instances when such a loss would be treated as a capital loss as opposed to a short-term loss (ordinary loss). Further, under the House Tax Proposals partnership indebtedness will be treated the same as corporate indebtedness for purposes of Section 165. The House Tax Proposals also include a new provision which will treat worthless partnership interest as a loss from the sale or exchange of a partnership interest at the time of the identifiable event establishing worthlessness. The provision will be effective beginning after December 31, 2021.
Provisions in the Green Book, But Not in the House Tax Proposals
15% Minimum Tax on Book Earnings of Large Corporations
The Green Book previously imposed a 15% minimum tax on worldwide pre-tax book income for corporations whose annual book income exceed $2 billion, to be effective for taxable years after December 31, 2021. The book tentative minimum tax is equal to 15% of worldwide pre-tax book income (after reducing book income by book net operating loss deductions) less general business credits and foreign tax credits. The excess of the book tentative minimum tax over the regular tax would result in a book income tax. The tax on book earnings was intended to target larger corporations who often engaged in tax avoidance strategies.
Repeal Deferral of Gain from Like-Kind Exchanges
A loophole in the U.S. tax system which was previously addressed in President Biden’s legislative tax proposals in the Green Book is notably missing in the House Tax Proposals. Commonly referred to as a like-kind exchange, Section 1031 allows transfers of real property with no corresponding taxable event for the seller if certain conditions are met. Under Section 1031, taxpayers have 180 days following the sale or exchange of real property to purchase a replacement property, deferring the appreciated amount until a later recognition. The Green Book intended to repeal like-kind exchanges for sales or exchanges of real property where annual gain deferral would exceed $500,000 for individual filers or $1 million for married individuals filing jointly. Any gain in excess of these thresholds would be recognized by the taxpayer in the year the taxpayer transferred the real property. Taxpayers who have been scrambling to complete their exchanges prior to the end of the year can rest easy knowing this tax saving strategy will exist for the foreseeable future.
State and Local Tax Cap
The TCJA enacted state and local tax (“SALT”) deduction caps of $10,000 for individuals who itemize deductions through 2025 for property taxes plus state income or sales tax, but not both. Residents living in high income tax states were limited in the amount of deductions they could claim for their state and local taxes on their federal tax returns. Many Democrats are calling for a full repeal of the SALT cap. Although an amendment to the SALT cap is missing from the House Tax Proposals, there is an indication that “meaningful language” would be added to the House Tax Proposals at a later time to address the SALT cap.
Estate and Gift
Income Tax Rate Increase for Estates and Trusts
Estates and Trusts filing income tax returns are also subject to a change in income tax rate under the proposed legislation. Currently, estates and trusts with taxable income over $12,500 are subject to a 37% tax rate. The proposed legislation would increase the tax rate to 39.6%.
The house proposes a brand new section applicable to Grantor Trusts—a trust over which the grantor or other owner retains the power to control or direct the trust’s income or assets. These types of trusts are disregarded as separate tax entities for income tax purposes and all income is taxed to the grantor, rather than separately to the trust itself.
The largest impact of this proposed new section is that if a grantor is determined to be the “deemed owner” of the trust, or of any portion of the trust, that trust (or that portion) will be includable in the Grantor’s estate at the Grantor’s death. Further, any distribution made during the Grantor’s lifetime to anyone other than the Grantor or the Grantor’s spouse will be treated a gift. Currently, Grantor trusts are often used in order to allow the grantor to continue to have control of the assets, and allow that income to be taxed to them at the individual level, rather than at the trust tax rate, while pushing the assets out so that they are not includable in the grantor’s gross estate at their death.
Additionally, the new section treats sales between a grantor trust and its deemed owner as equivalent to a sale between the deemed owner and a third party. Under the current laws, because a grantor trust is taxed at the individual level, when a grantor sold appreciated assets to the grantor trust, no capital gain would be triggered. Under the proposed changes, in that scenario, gain would be recognized on such a sale and would deny the recognition of a loss. This would also impact the ability to “swap” assets of equal value between a grantor and the grantor trust—a practice commonly used to move high-basis assets into a trust in exchange for low-basis assets.
This language, if passed as-is, will impact any grantor trust established after December 31, 2021andwould apply to contributions made to existing grantor trusts which are made after December 31, 2021. The result of this language will mean that use of Grantor-Retained Annuity Trusts (GRATs), Intentionally Defective Grantor Trusts (IDGTs), and Spousal Lifetime Access Trusts (SLATs) would either no longer be beneficial at all or would need to be drafted particularly carefully to avoid triggering adverse consequences of these proposed new rules. Additionally, insurance trusts will be subject to the same concerns and most concerningly, while existing insurance trusts (established on or before December 31, 2021) would be grandfathered in, premiums paid by the insured after December 31, 2021 would be estate taxable.
The proposed grantor trust rules which serve to bring trust assets back into the taxable estate of the grantor will effectively eliminate the usefulness of certain estate planning strategies, and will require the exercise of extreme caution in drafting newly created grantor trusts (or making contributions to existing grantor trusts) after December 31, 2021. Coupling these considerations and the potential significantly reduced estate and gift exemption amount, many individuals will be looking to take advantage of lifetime gifting strategies to remove assets from their taxable estate before December 31, 2021.
Net Investment Income Tax Expansion for High Income Individuals, Trusts, and Estates
As noted above, the house tax proposal expands the Net Investment Income Tax (NIIT) of 3.8% in order to cover net investment income which is derived from a trade or business for high income taxpayers, but also further imposes this tax on trusts and estates.
Estate & Gift Tax Exemption
The current estate tax lifetime exemption, also known as the “unified credit” is $11.7 million per individual and applies to gifts and estate taxes combined. The current exemption amount applies to tax years up through 2025, at which point the exemption is set to return to the previous $5.49 million, adjusted for inflation. The house tax proposal terminates the temporary increase in the unified credit and reverts the credit back $5 million, as it was in 2010, indexed for inflation, beginning on January 1, 2022.
Estate Tax Valuation Reduction for Real Property used in Farming or other Trade or Business
In general, assets within a decedent’s gross estate are to be valued at their “highest and best use” for estate tax calculation purposes. Currently, the law allows for an alternative method of computation for certain real property used in farming or in a trade or business, if it meets certain criteria, and allows the valuation to be based on the property’s actual use rather than solely fair market value. The current provisions allows for a reduction of $750,000. The house proposal increases this reduction to $11,700,000.
Individual Retirement Accounts
The house tax proposal makes significant modifications to the treatment of Individual Retirement Accounts (IRAs) with respect to high income taxpayers, which will also have an impact on overall inheritance, estate and tax planning.
First, the proposed legislation places a cap on contributions to a Roth or traditional IRA for a taxable year if the total value of the IRA and other defined contribution retirement accounts exceed $10 million at the end of the prior taxable year. This would apply to high income taxpayers (individuals or married filing separately with taxable income over $400,000, married filing jointly with taxable income over $450,000, and heads of household filers with taxable income over $425,000).
Increased RMD for “Excess Balances”
Additionally, if a high income taxpayer’s combined retirement accounts (traditional IRA, Roth IRA, and defined contribution retirement accounts) have a balance of over $10 million at the end of the taxable year, a Required Minimum Distribution (RMD) would be required the following year equal to 50% of the excess of the $10 million threshold. Further, if the cumulative retirement account balances exceed $20 million, the RMD is equal to 100% of the excess of the account required to bring the total account balances down to $20 million, or, alternatively, the aggregate balance of the Roth IRAs. “High income taxpayer” is defined by the same thresholds as noted above with respect to contribution caps.
Elimination of Back-Door Roth IRA Strategies
The House Tax Proposals also effectively eliminate the use of “back-door” Roth IRA strategies in that they eliminate Roth IRA conversions (including Roth IRAs and employer-sponsored plans) for single and married filing separately taxpayers with taxable income over $400,000, married filing jointly with taxable income over $450,000, and heads of household with taxable income over $425,000.
Provisions in the Green Book, But Not in the House Tax Proposals
With respect to the Trusts and Estates space, the Green Book highlighted a desire to eliminate the basis “step-up”—in other words, an appreciated asset owned by a decedent would undergo a realization event at the owner’s death, and gains would have to be recognized at that time. The current law allows those inheriting those assets to adjust the basis to the value as of the date of the decedent’s death—rather than the basis the decedent had during their lifetime. Thus, at the date of death, there is neither a gain nor a loss for the beneficiary taking that asset. Eliminating the “stepped-up” basis rules would have a significant impact on estate planning strategies. This proposed change was not included in the House Tax Proposals.
Additionally, while the Green Book and Biden Administration have been generally vocal on eliminating or reducing the amount of generational wealth that can be passed on with little or no tax capture, the House Tax Proposals were entirely silent on changes to the generation-skipping transfer tax or to treatment of dynasty trusts. However, treatment of these items could theoretically make an appearance in further amendments and/or at the Senate level.
Tax Rate Changes
Corporate Tax Rate
Under current law, corporations are subject to a 21% flat tax. While both the Green Book and the House Tax Proposals have included proposals to increase the corporate income tax rate from the current 21%, the House Tax Proposals differ in their preferred tax rates. The Green Book proposed a tax rate increase to 28% for taxable years beginning after December 31, 2021, which included a phase-in rule for non-calendar year corporations. The House Tax Proposals include a graduated rate structure, which would provide an 18% rate for the first $400,000 of income, a 21% rate on income between $400,001 up to $5 million, and a 26.5% rate on income in excess of $5 million. The House Tax Proposals also includes an additional tax of the lesser of 29.5% or $287,000 for corporations with taxable income in excess of $10 million.
International Tax Changes
Replacing BEAT with the Stopping Harmful Inversions and Ending Low-Tax Developments (“SHIELD”) Rule
The Green Book proposed a full repeal of the Base Erosion and Anti-Abuse Tax (“BEAT”) under Section 59A of the Internal Revenue Code and introduced new SHIELD rules. The current proposal does not include the SHIELD, but rather modifies the BEAT rules by providing two new increased thresholds of 12.5% and 15% for tax years beginning after December 31, 2023 and December 31, 2025, respectively. The House Tax Proposals also modify the current definition of modified taxable income and base erosion payments for purposes of Section 59A.
Lastly, the House Tax Proposals provide a new exception for payments subject to U.S. tax, and for payments to foreign parties that were subject to an effective tax rate of foreign tax equal to or greater than the applicable BEAT rate, and limit the exception to the provision for taxpayers with a low base erosion percentage to taxable years beginning before January 1, 2024. This provision is effective for taxable years beginning after December 31, 2021.
GILTI and FDII
The House Tax Proposals, mostly consistent with the Green Book, proposed several changes to the Global Intangible Low Tax Income (“GILTI”) and Foreign-Derived Intangible Income (“FDII”) regimes enacted by the TCJA. Included in these changes are a reduction of the Section 250 deduction with respect to both FDII and GILTI. Where the House Tax Proposals and Green Book differ is the amount of the reduction for each FDII and GILTI. The Green Book previously called for a reduction of the Section 250 deduction from 50% to 25%, the House Tax Proposals have raised the deduction from 25% to 37.5%. Along the same lines, FDII deductions-- currently 37.5% and reduced to 21.875% for taxable years after December 31, 2025-- will now be reduced to 21.875% beginning in years after December 31, 2021. The House Tax Proposals also include a new transition rule so the new regime applies to taxable years that include (but do not need to end on) December 31, 2021.
Further, the Green Book previously called for a full repeal of FDII on the basis that FDII is not effective in promoting research and development activities in the U.S. and does not incentivize new domestic investment while creating undesirable incentives to locate economic activity overseas.
Finally, the House Tax Proposals are no longer calling for the removal of Qualified Business Asset Income (“QBAI”), which serves as an exemption for U.S. multinationals based on the value of their tangible property for both the GILTI and FDII amounts.
S Corporation to Partnership Transition Period
At first glance, the House Tax Proposals would appear to provide an important tax benefit for shareholders of S corporations desiring to convert to partnership tax status. Under current rules, Section 311(b) of the Internal Revenue Code may impose a material tax burden on S corporations with substantially appreciated assets.
The House Tax Proposals provide a temporary rule allowing certain S corporations to reorganize as partnerships without an income tax consequence. However, to be eligible for this benefit the converting S corporation must have been an S corporation on May 13, 1996, and at all times thereafter through the date of the conversion. Although May 13, 1996 was the day prior to the date on which the House Committee on Ways and Means scheduled a markup of the Small Business Job Protection Act, which made important changes to the tax treatment of S corporations, it is unclear why this relief should be targeted to only S corporations existing on that date through the present.
For more information, please contact Michael Cumming ( [email protected] or 248-203-0740), Scott Kocienski ( [email protected] or 248-203-0868), Richard Lieberman ( [email protected] or 312-627-2250), Asel Lindsey ( [email protected] or 210-554-5298), Nardeen Dalli ( [email protected] or 248-203-0793), Victoria Remus ( [email protected] or 248-203-0553), Lisa Hendrix Weigel ( [email protected] or312-627-2296),or your local Dykema relationship attorney.
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