There has been a great deal of discussion about all the potential tax changes included in President Biden’s $3.5 trillion budget proposals. The House Ways and Means Committee has advanced legislation that contain elements of these proposals. This legislation is substantially less radical than President Biden’s proposals. Since these scaled back provisions are the result of numerous negotiations between law makers, we believe that the final legislation will be much more similar to these proposals than to President Biden’s original proposals. Despite these proposals being more moderate, they still make major changes to federal tax law, and you should be aware of how they might affect your taxes. Please call us to discuss how these provisions will affect you.
Each item in the following summary has more detail later in this newsletter for further information:
- Raises the income tax rates for individuals, trusts, capital gains, dividends, and corporations.
- Applies the 3.8% net investment income tax to trade or business income for trusts and high-income individuals.
- Applies a cap of $500,000 for married joint ($400,000 single, $250,000 married joint, and $10,000 trust) to QBI deductions.
- Accelerates the reduction of the estate and gift tax lifetime exclusion.
- Elimination of intentionally defective grantor trusts.
- Elimination of valuation discounts for nonbusiness assets.
- Reduction in the tax benefits on gains for 1202 stock.
- Eliminate contributions and require larger distributions from large retirement plan account balances.
- Eliminate Roth Conversions for High Income Taxpayers.
- Limit investments eligible to be held by IRAs.
- Extend the holding period for capital gain treatment for carried interests to five years.
- Extend constructive sale rules to digital assets.
- Changes for multinational businesses.
Raise Income Tax Rates
The proposal increases the top individual tax rate to 39.6% and adds an additional 3% tax on adjusted gross income in excess of $5 million ($2.5 million for married separate). The 39.6% rate applies to income over $450,000 for married joint, $425,000 for head of household, $400,000 for single, $225,000 for married separate, and $12,500 for trusts. If a taxpayer’s adjusted gross income is over $5 million, the total marginal rate on the excess is taxed at 42.6%. These increases take effect for 2022 tax years.
The proposal also increases the capital gains tax rate to 25% for any gains currently subject to a 20% tax rate. The higher rate would apply to any transactions after the introduction of the legislation.
The proposal changes the tax rate for C corporations to a graduated tax with the first $400,000 of income taxed at 18%, Income from $400,000 to $5 million taxed at 21%, and income over $5 million taxed at 26.5%. The benefits of the lower brackets phase out for corporations making in excess of $10 million. Professional service corporations are not eligible for the benefits of the graduated rates.
Application of 3.8% Net Investment Income Tax to Trade or Business Income
The proposal applies the 3.8% net investment income tax to trade or business income for trusts and for individuals with taxable income over base amounts. The base amount is $500,000 for married joint, $400,000 for single. The tax applies to all trade or business income of trusts including flowthrough from partnerships and S corporations.
Application of Cap on QBI Deductions
The proposal caps the total amount of QBI deduction an individual or trust is allowed each year. The most QBI that can be claimed in a year is $500,000 for a joint return, $400,000 for an individual, $250,000 for married separate, and $10,000 for a trust. As a result, the QBI deduction no longer reduces the maximum tax rate on business income. The adjustments described above without reduction for QBI over the limit means that business income now carries a maximum marginal tax rate of 46.4% as shown below:
|Total Federal Tax Rate||46.4%|
Acceleration Reduction in Gift/Estate Tax Lifetime Exclusion
The proposal eliminates the temporary doubling of the lifetime gift and estate tax exclusion. The exclusion would revert to the $5 million exclusion adjusted for inflation. That inflation adjusted limit would be $5.85 million with the current inflation adjustment.
Elimination of Intentionally Defective Grantor Trusts
It is currently popular to create an intentionally defective grantor trust (IDGT) for estate tax planning purposes. The proposal would force trusts that are treated as grantor trusts for income tax purposes to also be treated as a grantor trust for estate and gift tax purposes. The treatment of trusts already created is grandfathered under the old rules.
Elimination of Valuation Discounts for Nonbusiness Assets
The provision would remove the use of any valuation discounts for nonbusiness assets. This provision will have the effect of increasing the value of some investment assets for estate and gift tax purposes if those assets are held through a vehicle that provides limited control.
Reduction in the Tax Benefits on Gains for 1202 stock
If an individual disposes of 1202 stock, that individual can currently exclude the capital gain on the disposal of the stock for either $10 million or ten times the tax basis in the stock. The proposal would limit the exclusion to 50% of the gain on the disposal of the stock. The new rules would apply to gains realized after September 13, 2021.
Large Retirement Plan Balances
If an individual has retirement plan balances in excess of $10 million, that individual would be required to take annual distributions of half of the excess of fair market value of the plan over the $10 million limit. In addition, the individual would be prohibited from making further contributions to retirement plans. Individuals with taxable income less than $450,000 married joint, $425,000 head of household, and $400,000 single would be exempt from this requirement. Since the annual distributions would likely exceed these income limitations, taxpayers who are subject to these rules would likely continue to fall under them for the foreseeable future.
In addition, an individual with retirement plan assets in excess of $20 million would be required to distribute from the Roth assets the lesser of the total Roth assets or the excess over $20 million in total retirement plan assets. Once this distribution is made, the individual can choose from which retirement accounts to distribute the remainder of the 50% distribution in the paragraph above.
Eliminate Roth Conversions for High Income Taxpayers
The proposal would eliminate the ability of taxpayers with income over the limit from converting regular IRAs or employer sponsored retirement plans to Roth balances. The income limits are taxable income over $450,000 for married joint, $425,000 for head of household, or $400,000 for single or married separate. These taxpayers would no longer be able to do “backdoor” Roth contributions.
Limitations on Assets That Can be Held by IRAs
Under the current law, IRAs can hold securities that are only offered to accredited investors (securities not registered under federal securities laws). Under the proposal, if an IRA holds one of these securities, it would lose its status as an IRA. The result would be to treat the fair market value of that IRA as a distribution to the owner. The rule takes effect beginning in 2022 but allows a two-year transition period for IRAs to dispose of current holdings.
In addition, the proposal would prohibit IRA ownership in a investment in a non-public investment if the IRA owner owns at least 10% of that entity either directly or indirectly.
Under currently law, carried interests must be held for three years in order for gains from selling those interests to be treated as capital gains. The proposal would extend that holding period to five years unless the taxpayer has adjusted gross income less than $400,000.
Constructive Sale Rules for Digital Assets
Most financial assets are currently subject to rules requiring the holder to recognize gains if they acquire an offsetting provision to lock in unrealized gains. The proposals would extend those rules to digital assets such as cryptocurrencies. The proposals would also apply the wash sale rules to digital assets. The wash sale rules prohibit taxpayers from recognizing losses on the disposition of securities if they re-acquire the asset within a short time period.
The proposals make several changes to provisions that apply to multinational businesses:
- The section 250 deduction is reduced so that the GILTI rate will be 16.5625% and the FDII rate will be 20.7%.
- The proposals change the calculation of GILTI to be determined country by country rather than in aggregate.
- The one-month difference in reportable tax year of specified foreign corporations is no longer allowed.
- Foreign tax credits for dual capacity taxpayers are limited to the income multiplied by the generally applicable income tax of the foreign country.
- Foreign tax credit calculations must be applied country by country instead of in aggregate.
- The interest deduction of certain domestic corporations who are members in an international financial reporting group is limited if the average annual interest expense exceeds $12 million.
- The proposal increases the BEAT rate to 10% through 2023, 12.5% for 2024-2025, and 15% for 2026 and later years.
These changes are extensive and can have dramatic impacts on your future taxes. If you have questions about how the proposal affects your taxes or transactions that you are considering, call your WhippleWood us for guidance, or click here to email our team.