On Sunday, Sept. 12, 2021, House Democrats outlined revenue raisers needed to offset a $3.5 trillion spending package. Then, on Monday, Sept. 13, 2021, House Ways and Means Committee Chairman Richard Neal (D-Mass.) circulated a draft bill that would ‘preliminarily’ raise $2.9 trillion from proposed tax increases and enhanced taxpayer compliance (mostly from increased IRS funding). This document is an expected development, indicative of a further step in the legislative process towards a potential tax and spending reconciliation package enacted later this fall or winter. Unless otherwise noted, the provisions described below would generally be effective for tax years beginning after Dec. 31, 2021.
It is important to remember that these proposed changes must still proceed through several additional steps before they move out of Congress to the President, all the while subject to a highly politicized and unpredictable process.
The tax proposals, as anticipated, target wealthy individuals and corporations, with additional funding for IRS enforcement.
- Increase in the top individual rate to 39.6% (top marginal bracket beginning at taxable incomes over $450,000, $425,000 or $400,000 for married individuals filing joint, heads of households or unmarried individuals, respectively)
- A 3% surcharge on individuals with adjusted gross income greater than $5 million. For trusts, the surtax applies at $100,000 of income
- Increase in the top capital gains rate from 20% to 25% with an effective date of Sept. 13, 2021. Note the effective date provision states taxable years ending after Sept. 13, 2021, with transition rules for taxable years that include Sept. 13, 2021
- An increase in the top corporate tax rate to 26.5% for business with taxable income in excess of $5 million (21% for income between $400,000 and $5 million; 18% for business with taxable income below $400,000)
- A global minimum rate under GILTI of ‘about 16.5%’ with a 5% QBAI exemption and an apparent 5% haircut on FTCs, along with a proposal to calculate GILTI on a country-by-country basis
- A detailed proposal to impose a per country limitation with respect to the calculation of the foreign tax credit
- Changes to the BEAT regime include an increased rate (10% for two years; 12.5% thereafter. An accelerated reduction in the FDII deduction to 21.875% (currently scheduled to occur in 2025)
- A delay in effective date of required research and experimentation capitalization and amortization from tax years beginning after Dec. 31, 2021 to tax years beginning after Dec. 31, 2025
- Acceleration of the scheduled expiration of the current $12 million estate and gift tax exemption per taxpayer ($24 million for married couples) to Dec. 31, 2021
- Increased funding for the IRS
A deeper dive on individual and pass-through items
In addition to the increase in the top-line marginal rate and the 3% surcharge on high-income individuals, estates and trusts, the proposal sets a ceiling on the maximum allowed qualified business income deduction under section 199A. This ceiling, set at $500,000 for married individuals filing a joint return, $250,000 for a married individual filing a separate return, $10,000 for trusts and estates or $400,000 for other taxpayers, could cause a significant increase in the effective tax rate of a high income individual.
’Active’ investors in pass-through entities would see additional increases under the proposal which would impose the net investment income tax (NIIT) on business income regardless of participation level of the owner, with exclusions for income on which FICA or SECA is already imposed. As a result, most income from pass-through entities would be subject to a 3.8% tax under the SECA (Self-Employment Contributions Act), FICA (Federal Insurance Contribution Act) or the NIIT regimes.
Retroactivity and the capital gains rate increase have been the topic de jour for some time. The release of this amendment clarifies the starting point and effective date for the capital gains provisions. Until this point, unlike Sen. Wyden and Senate Finance, House Ways & Means had not addressed the 20% qualified business income deduction under section 199A. Under the House Ways & Means draft, the section 199A deduction would be capped at $500,000 for a joint return, $250,000 for a married individual filing a separate return, $10,000 for an estate or trust or $400,000 for any other taxpayer. Accordingly, a married taxpayer filing a joint return, with a qualifying trade or business would be subject to this cap at $2.5 million of qualified business income, while an individual taxpayer would be subject to this cap at $2 million of qualified business income and a trust would lose section 199A benefits on income exceeding $50,000.
Taken all together, taxpayers with successful business operations may face a federal tax rate of up to 46.4%, a sharp increase from the current 29.6% rate today, after taking into account, the full 20% qualified business income deduction.
The proposal would also modify and make permanent the excess business loss limits for noncorporate taxpayers. Under the Tax Cuts and Jobs Act, noncorporate taxpayer’s excess business losses are limited to $250,000 (200% of such amount in the case of a joint return), indexed for inflation. Under present law, the excess business loss limitation is set to expire for taxable year beginning before Jan. 1, 2027. In addition to the permanency provision, the proposal modifies how an excess business loss is carried forward from year to year.
Tucked into the tail end of the proposal is a provision to temporarily allow a tax-free conversion of an S corporation to a partnership during a specified two-year window. While limited in scope to only S corporations that were in existence prior to or on May 13, 1996, this provision might be attractive for S corporations and their owners looking to restructure operations, distribute appreciated assets or that otherwise desire the flexibility provided under the partnership tax rules.
The proposal also modifies several aspects of the carried interest rules including:
- Extending the holding period required for long-term capital gains treatment from three years to five years. This extension would not apply to real property trades or businesses or for taxpayers with AGI of less than a specified threshold.
- Extending applicability of carried interest rules to include any asset eligible for long-term capital gains treatment. This would bring the sale of business assets, including real estate under the purview of these rules.
- Extending regulatory authority under the provision to address carry waivers and other transactions designed to circumvent or avoid these rules.
The proposal makes certain unfavorable changes to the characterization of certain losses with respect to partnership investments:
- It subjects losses on the worthlessness of a partnership interest (potentially ordinary under current law) to the same rules as losses on the sale of a partnership interest (generally subject to capital loss treatment).
- It classifies certain types of partnership debt as securities, generally resulting in capital loss characterization (rather than ordinary loss) for losses realized with respect to these types of debt.
The ‘excess business interest’ deduction disallowance rules of section 163(j) apply under the proposal to the owners of pass-through entities. The interest disallowance computations would be applied at the owner level (i.e., the partner or the S corporation shareholder level) rather than at the business entity level (i.e., the partnership or S corporation level).
Focus on corporate and international
To raise almost $3.5 trillion requires significant increases to rates and tweaks to existing law. While a 25% corporate rate has been signaled for some time, companies may have been surprised to see the rate tick up to the 26.5%. Also signaled for some time were changes to the TCJA enacted international tax regime. However, the House Ways & Means proposal differs from the Administration’s Green Book and from the Senate Finance discussion draft, which could mean some back-and-forth as the tax writers work toward consensus in international taxation.
Some of the other changes to international taxation include a further interest deduction restriction for U.S. multinationals with U.S. operations and debt located in the U.S. In addition, the proposal restricts the ability to carryforward disallowed business interest expense to a maximum of five tax years. The five-year expiration period would apply both to carryforwards under this new restriction and to carryforwards under the existing section 163(j) from interest pair or incurred in taxable years beginning after Dec. 31, 2021. Also, a change to dividend treatment related to controlled foreign corporations (CFCs), effective upon the date of enactment, could result in reduced tax basis of the U.S. shareholder in the CFC, which leads to higher gains upon disposition.
There are a variety of important technical changes to key international provisions that could be significant and some of these are proposed to be effective on a retroactive basis. For example, a proposal to scale back the income base used to calculate the FDII deduction would be effective for taxable years beginning after Dec. 31, 2017. This could result in the need for amended returns, although it is not clear whether there is broad support for tax code changes that would force taxpayers to amend returns for several years.
Other corporate items include a restriction on special rules related to the exclusion of gain on the sale of small business stock. The proposal limits the application of the 75% exclusions and 100% exclusion rules to taxpayers with AGI of less than $400,000. In addition, the proposal disallows the ability for trusts and estates to utilize these exclusions. Importantly, the proposal has an immediate effective date and would apply to sales or exchanges of stock on or after Sept. 13, 2021.
The changes to the section 1202 exclusions could substantially diminish the value of section 1202. Further, it could make it more difficult for small companies to raise money, as we believe the section 1202 benefit has been a significant driver in investment activity in small business. At present, there is currently no income limitation for the exclusion and the change would limit the benefit of the current 100% (75% in some cases) exclusion to only taxpayers with AGI of less than $400,000. While the 50% exclusion remains available for all qualifying taxpayers, the mechanics of the calculation make the exclusion significantly less valuable.
The proposal also includes a provision that would significantly limit certain tax benefits available to companies engaging in tax-free leveraged spin-off transactions. This provision would primarily impact very large companies; middle-market and smaller companies more rarely implement leveraged spin-offs.
Estate and gift and other provisions
While the proposal does not go as far as the Administration’s Green Book in eliminating the step-up in basis in estates, there are still significant changes to the taxation of estates and gifts. The surcharge applicable to high-income taxpayers also applies to estates and trusts, with applicability of the 3% surcharge starting at modified adjusted gross income exceeding $100,000.
In addition, assets contributed to a grantor trust after the date of enactment would be included in the grantor’s estate and sales by a grantor to a grantor trust that is not revocable would be taxed. Also, the proposal eliminates the valuation discount in the case of nonbusiness assets, which would include real estate investments the extent the transferor does not participate more than 750 hours.
Also, the proposal moves up the expiration of the temporary increase in the estate and gift tax exemption amounts. So rather than an $11.7 million exclusion per individual, the proposal resets the amount to $5 million, adjusted for inflation. For 2022, with inflation taken into account, the exclusion amount would be approximately $6 million.
Under the proposal, special rules limit company tax deductions with regard to compensation of certain highly paid employees of publicly traded companies. This proposal moves up the effective date of the expansion of the public company $1 million compensation limitation (from five covered employees to up to 10 covered employees) from tax years beginning after Dec. 31, 2026 to tax years beginning after Dec. 31, 2021.
The proposal increases funding for the IRS by approximately $79 billion for the IRS to enhance enforcement activities, increase voluntary compliance and modernize information technology. These funds are not intended to be used to increase taxes on taxpayers with taxable income below $400,000. In addition, the proposal repeals the requirement of the IRS Restructuring and Reform Act of 1998 that assessments of certain penalties be approved by a supervisor of the IRS employee making a penalty determination. The amendment applies to penalty notices issued after the date of enactment of this provision.
Finally, but again, not all inclusive of all the proposals contained within the amendment, the proposal modifies the characterization of digital assets, including cryptocurrency and subjects these assets to the constructive sale and wash sale rules. The loss-disallowing wash sale rules (which apply, for example, to certain sales of securities followed by acquisition of substantially identical securities) and the gain-triggering constructive sale rules (which apply, for example, to ‘short against the box’ stock positions) apply only to specifically enumerated asset types, and previously did not apply to digital assets.
This is an extensive menu of potential payfors but whether it will be embraced by the broader caucus in the House and importantly, in the Senate remains to be seen. In addition, items that have been commented as critical items, such as the state and location deduction cap, are not in this proposal. RSM will be monitoring this situation closely as it plays out over the next few days, and will provide further insights in our external webcast on Sept. 21, 2021.