The tax proposals are expected to raise taxes by more than $2 trillion over the next 10 years in an effort to offset the $3.5 trillion in spending through tax relief packages.
During the week of September 13, 2021, House Democrats marked up and advanced key tax provisions in the Build Back Better Act with different portions of the bill passing their respective committees, including the tax provisions clearing the Ways and Means Committee. Prior to the committee’s markup last week, the full statutory text of the tax provisions exceeded 880 pages.
The proposal is currently under consideration by the House Budget Committee and House Rules Committee, where it needs to be approved before the entire package is voted on by the full House. Democratic leaders had hoped to hold a vote in late September, however that appears increasingly unrealistic and unlikely. The timing of the bill’s advancement is currently unclear as they seek to ensure they have the votes necessary to pass the proposed legislation. We expect meaningful changes to the current proposals before any final passage, as multiple House and Senate members have expressed concerns over the price tag and contents of the bill. Moderate House and Senate Democrats are expected to insist on scaling back the scope of both the spending proposals and important tax increase proposals. Nevertheless, Democratic leaders are motivated to finalize the legislation so it can be signed into law by President Biden before the end of the year.
As we discussed previously, the tax initiatives contained in this bill are closely tied to the $1 trillion infrastructure bill passed by the Senate and currently pending in the House. According to latest estimates by the Joint Committee on Taxation, the tax proposals are expected to raise taxes by more than $2 trillion over the next 10 years in an effort to offset the $3.5 trillion in spending through tax relief packages.
As the Build Back Better Act moves forward, it will certainly change. During its evolution, we will advise on available planning opportunities. Below, we provide a high-level overview of key contents of the bill as initially presented, so you may begin to game plan for year-end, which may shape your most important tax planning strategies in decades. Most of the provisions below have a proposed effective date of January 1, 2022, with the notable exception of the increase in the capital gains rate, which would be effective September 13, 2021, the date the proposal was released.
Business Tax Proposals
Corporate Tax Rate Increased
For C corporations, the tax rate would be changed from a flat 21 percent under the current law to a graduated rate: 18 percent on the first $400,000 of income, 21 percent on income between $400,000 and $5 million, and 26.5 percent on income in excess of $5 million. For corporations making over $10 million, the benefit of the graduated rates on income under $5 million will be phased out.
International Tax Regime Changed
The bill also makes substantial changes to the international tax regime, including FDII (foreign-derived intangible income), GILTI (global intangible low-taxed income) and BEAT (base erosion and anti-abuse tax). Perhaps most notable are the changes to the foreign tax credit; the bill proposes reducing the carryforward period for foreign tax credits from 10 years to five, and eliminating the tax credit carryback. These modifications will substantially limit taxpayers’ ability to utilize excess foreign tax credits caused by high foreign tax rates.
Gain Exclusion for Qualified Small Business Stock Limited
For qualified small-business stock acquired in 2009 or later, either 75 percent or 100 percent of the gains from the sale of the stock is excluded from income, depending on the date of acquisition. Under the draft legislation, these special exclusions would not be available for taxpayers with an adjusted gross income (AGI) of $400,000 or more. These taxpayers would only be able to utilize the 50 percent gain exclusion.
Excess Business Losses Limitation for Noncorporate Taxpayers Extended
Currently, under IRC Section 461(l), non-C corporation taxpayers cannot deduct business losses in excess of an inflation-indexed $250,000 for most taxpayers (and $500,000 for married filing jointly taxpayers) against other, nonbusiness income, such as wages and investment income. The proposal would make this limitation, currently set to expire on December 31, 2026, permanent. In addition, the proposal subjects the disallowed loss to the same threshold in subsequent years, rather than allowing the loss to become a net operating loss under IRC 172, substantially increasing the difficulty in claiming the loss.
Work Opportunity Credit Enhanced
The bill also proposes several modifications to the Work Opportunity Credit through December 31, 2023. Currently, the credit for most target groups is 40 percent of qualified wages up to $6,000 for a credit amount of $2,400. In addition, the law only allows the credit to be claimed on the wages for the first year after hire. The proposal increases the credit to 50 percent of up to $10,000 of qualified wages, including those paid in the second year after hire, for all target groups except summer youth employees.
Employer Credit for Paid Family Leave and Medical Leave Sunsets Earlier
The bill proposes eliminating the Employer Credit for Paid Family Leave and Medical Leave two years earlier than currently scheduled―for tax years beginning after 2023, rather than tax years beginning after 2025.
S Corporations May Reorganize as Partnerships
The proposed legislation also includes a temporary rule allowing S corporations in existence on May 13, 1996, to convert to a partnership anytime in calendar year 2022 or 2023 without triggering a tax liability.
Individual Tax Proposals
Top Marginal Tax Rate Increased
One of the most anticipated provisions in the proposal is the increase in the top individual income tax rate to 39.6 percent. The new rate would be effective for married taxpayers filing jointly with taxable income over $450,000, heads of household with incomes over $425,000, single taxpayers with incomes over $400,000 and married filing separately taxpayers with incomes over $225,000. This change would effectively eliminate the current 37 percent bracket, and even subject many taxpayers currently in the 35 percent bracket to this proposed 39.6 percent rate.
High-Income Surtax Imposed
Additionally, a new surcharge of 3 percent on high-net-worth taxpayers with adjusted gross incomes in excess of $2.5 million for married taxpayers filing separately, $100,000 for trusts and estates and $5 million for all other filers would take effect beginning in 2022.
Capital Gains Rate Increased
The bill also includes a provision that raises the current top capital gains rate (and presumably the qualified dividend income tax rate) from 20 percent to 25 percent. The proposal would maintain the current zero percent and 15 percent brackets, as well as the current thresholds delineating the brackets. Uniquely, this provision could be applicable in 2021, as it applies to sales occurring on or after September 13, 2021. Transitional rules apply for sales entered into prior to September 13.
Net Investment Income Tax (NIIT) Expanded
The draft legislation also proposes applying the 3.8 percent net investment income tax to net investment income derived in the ordinary course of a trade or business, or to the disposition of property earned outside of a passive activity, both previously excluded from NIIT, for taxpayers with taxable incomes in excess of $400,000 for single filers, $500,000 for joint filers and $250,000 for separate filers. As a result of this expansion, gains arising from the sale of pass-through businesses would be subject to the 3.8 percent NIIT.
Qualified Business Income (QBI) Deduction Limited
The proposal limits the QBI deduction for pass-through income by limiting the total dollar value of the deduction based on filing status. The deduction would be limited to $500,000 for joint filers, $400,000 for single filers, $250,000 for married filing separately filers and $10,000 for trusts and estates. Existing rules do not set any limits on the maximum allowable deduction.
Retirement Contributions Reduced
For high income individuals with taxable incomes over $400,000 (single and married filing separately), $425,000 (heads of household) or $450,000 (married filing jointly), the bill prohibits additional contributions to a Roth or traditional IRA if the taxpayer’s IRA and defined contribution plan balances exceeded $10 million at the end of the prior tax year.
Minimum Required Distributions Increased
For taxpayers subject to the above contribution limit with retirement balances over $10 million and taxable incomes over $400,000, $425,000 or $450,000, as applicable, the bill also requires the taxpayers to take minimum distributions from the plans. Generally, the minimum distribution is 50 percent of the excess of the balance over $10 million. In addition, for those with balances over $20 million, taxpayers must withdraw the lesser of the excess over $20 million or their Roth balances in IRAs and defined contribution plans. Only after application of this new Roth rule is the additional 50 percent distribution calculated.
“Back-Door” Roth Conversions Eliminated
While under current law, contributions to Roth IRAs have income limitations, conversions from traditional IRAs to Roth IRAs do not. Therefore, to circumvent the Roth contribution limitations, many taxpayers make nondeductible contributions to a traditional IRA and follow that transaction with a (usually) tax free conversion to a Roth. The bill proposes closing this loophole by eliminating Roth conversions for taxpayers with taxable incomes above the income thresholds discussed above of $400,000/$425,000/$450,000. The bill also prohibits all employee after-tax contributions in qualified plans and prevents such contributions from being converted to Roth IRAs regardless of income level, beginning in 2022.
Child Tax Credit Expanded
In the American Rescue Plan passed in March 2021, the child tax credit was greatly expanded for 2021 only, including raising the maximum credit from $2,000 per child to $3,000 or $3,600 depending on the age of the child, adding eligibility for 17 year old children and increasing the amount of the credit available to individuals with low earned income. The draft legislation proposes extending these benefits through the end of 2025.
Interestingly, the bill does not include any proposed change to the $10,000 cap on individual itemized deductions for state and local taxes (SALT) enacted by the 2017 Tax Reform Act. However, Ways and Means Chairman Richard Neal of Massachusetts issued a statement on September 13 committing to include “meaningful SALT relief” in the final enacted legislation. See “TAG’s Perspective” below for further thoughts on tax implications of the SALT deduction.
Estate/Fiduciary Tax Proposals
Top Marginal Tax Rate Increased
The new top marginal income tax rate of 39.6 percent will apply to income earned by an estate or trust in excess of $12,500.
High-Income Surtax Imposed
The new income tax surcharge would also apply to estates and trusts with modified adjusted gross income above $100,000.
Net Investment Income Tax (NIIT) Expanded
The expanded definition of net investment income tax described above under "Individual Tax Proposals" will also apply to trusts and estates.
Lifetime Exemption Reduced
Under the Tax Cuts and Jobs Act of 2017, for the years 2018-2025, the lifetime exemption applicable to the estate and gift tax was effectively doubled, from an inflation-indexed $5 million to an inflation-indexed $10 million ($11.7 million in 2021). Under this proposal, the lifetime exemption would revert to an inflation-indexed $5 million (reduced to approximately $6,020,000 beginning on January 1, 2022). This provides a limited window for individuals to make full use of their current $11.7 million lifetime exemption.
Real Property Reduction Increased
For certain qualified real property used in a family farm or family business, decedents may value the property for estate tax purposes based on its actual use, rather than fair market value. Under current law, the reduction to actual use from fair market value is limited to a maximum of $750,000. Under the proposal, the maximum allowable reduction would be $11.7 million, allowing more family businesses to pass from generation to generation without fear of liquidation to pay the estate tax due.
Grantor Trusts Effectively Eliminated
The draft legislation enacts several IRC sections that take the teeth out of a popular wealth planning tool: grantor trusts. First, the proposal would pull grantor trusts into a decedent’s taxable estate when the decedent remains a deemed owner of the trusts. Second, the proposal also treats sales between grantor trusts and their owners as sales between third parties, including recognition of gain. It is important to note that these provisions are only applicable to future trusts and future transfers. The proposed changes would become effective after the date of enactment.
Valuation Discounts Eliminated
The draft legislation would eliminate the ability to utilize valuation discounts on the transfer of nonbusiness assets. This change may impair or eliminate the ability to utilize limited partnerships or limited liability companies as an efficient way of transferring assets to trusts or other family members. The proposed change would apply to transfers after the date of enactment.
Interestingly, the proposal does not include some of the hot tax topics previously targeted such as the elimination of the step-up in basis at death, an increase in the estate tax rate from 40 percent or the implementation of a progressive estate tax rate structure, limiting annual exclusion gifts to trusts, creating new limitations on the use of dynasty trusts, setting a minimum term for grantor retained annuity trusts and eliminating zeroed-out grantor retained annuity trusts, among others.
One provision in the bill affects all of the above-targeted groups: The bill increases IRS funding by approximately $80 billion. The great majority of the funds are specifically intended to be utilized on increased enforcement, particularly targeting taxpayers with taxable income over $400,000, which could substantially increase the risk of audit for high-income, high-wealth taxpayers. This proposal continues the trend of increased audit risk for high-net-worth individuals as we wrote about in a previous Alert.
As of this writing, the draft legislation does not contain a provision that would repeal the limitation on the deduction for SALT, which was introduced by the Tax Cuts and Jobs Act of 2017. This SALT cap disproportionally affects taxpayers from “blue” states that typically impose higher rates of state and local tax. As such, some Democrats view at least a partial repeal of the cap as a necessary component of any bill. However, since the SALT cap also hits the wealthy the hardest, the progressive members of the caucus are hesitant to enact a full repeal of the cap. Considering all of the tax increases included in the Build Back Better Act discussed above, with a SALT cap elimination, many wealthy taxpayers could see a net tax decrease from the law as a whole, which is an undesirable outcome for many legislators. Negotiations are underway on how high the SALT cap should be raised.
In any negotiation for a reconciliation package, the budgetary cost of individual provisions is paramount, as the entire bill must meet certain budgetary targets. As such, we are likely to see the inclusion of at least two large revenue raisers that were included in President Biden’s Green Book released in May, but which are currently absent from the House plan. Notably, additional bank reporting requirements, where financial institutions would have to report any cash inflows or outflows over $600, would have generated an estimated $462 billion under President Biden’s plan. Also missing from the House plan is a minimum tax on global book income, which would limit companies’ abilities to shift income offshore while generating an estimated $150 billion in revenue over 10 years.
Should you panic? No. Predict? Maybe. Plan? Absolutely. It is important to stay informed, stay engaged, stay agile and stay in touch with us as the legislation advances and beyond. Individuals, estate, trusts and businesses should model these new provisions and those likely to be enacted as part of final legislation to better understand the potential tax implications and to discuss tax planning strategies.
For More Information
If you would like more information about this topic or your own unique situation, please contact John I. Frederick, Michael A. Gillen, Steven M. Packer, any of the practitioners in the Tax Accounting Group, trust and estate attorneys David S. Kovsky and Erin E. McQuiggan of the firm’s Private Client Services Practice Group or the practitioner in the firm with whom you are regularly in contact. For information about other pertinent tax topics, please visit our publications page.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.