The information contained in this article is neither tax advice nor recommendations. It is a summary of some of the provisions from the various tax legislation and proposals from the 2022 federal fiscal year proposed budget submitted by the Biden Administration in May 2021, as presented in the Treasury Department’s “Green Book.” Please consult your tax advisor regarding the implications of these proposals to your individual situation.
An incredible amount of new Internal Revenue Service (IRS) guidance on Congress’s recent pandemic tax relief bills, fresh clarification of the Tax Cut and Jobs Act (TCJA) of 2017, and recent administrative proposals mean new taxes and tax rules for individuals, estates, asset transfers, partnerships, and corporations. Among them:
- Top marginal rates increase and start at lower income levels
- Long-term capital gains rate increases from 20% to 39.6% for those with adjusted gross income of more than $1 million
- Taxation of previously untaxed transfers of appreciated property, along with new gift and estate laws and income recognition events
- Punitive carried interest changes for investment partnerships
- Changes to recognition events for trusts and flow-through entities including multigenerational assets under a proposed 90-year rule
- New implementation of the 3.8% Medicare tax and self-employment contributions to trade and business income
- Higher corporate taxes
- Better IRS funding to enforce compliance
Calendar year 2020 was unprecedented. In addition to the worldwide COVID-19 pandemic, we also experienced a contentious election and an impeachment of the president of the United States, social unrest with large-scale protests, an economy that was severely impacted by large numbers of people out of work, and many businesses facing uncertain futures. We also had an unprecedented year in tax policy in the midst of everything else.
In 2020, Congress acted quickly and significantly to respond to the widespread closures that were necessitated by the pandemic. During the year, Congress passed three enormous tax bills in an effort to help many individuals who had lost jobs due to the pandemic closures and to help businesses survive the forced closures. Throughout 2020, the Internal Revenue Service was busy writing an incredible amount of guidance to implement the above-mentioned legislation, address additional issues as they arose, and to complete the guidance that was still needed for the Tax Cut and Jobs Act (TCJA) that was passed in December 2017.
As 2021 started, we knew there were going to be changes to the tax laws that we normally see with a new administration in Washington. However, this year has been off to an exceptionally quick start. Through the first week of June 2021, one new tax act and two proposals have emerged:
- The American Rescue Plan Act
- The American Jobs Plan
- The American Families Plan
The American Jobs Plan (including the Made in America Tax Plan), and the American Families Plan are still in process, with any legislation several months away.
- The American Jobs Plan is the Biden administration’s infrastructure plan, which includes many proposals for spending on traditional infrastructure projects like bridges, roads, and utilities, including electricity grids and internet access. The plan also expands the definition of infrastructure to include health care, job training, and schools. This proposal, which has an estimated cost of approximately $2 trillion dollars, will be primarily paid for by increasing the corporate tax rate to 28%.
- The American Families Plan includes various proposals based on promises that President Biden made during his presidential campaign. Included are extensions of some of the tax benefits in the American Rescue Plan Act of 2021, general tax reform meant to benefit middle- and lower-income taxpayers, housing and job support for middle-class families, and the addition of a total of four years of free public education: free universal preschool for all 3- and 4-year-olds, and two free years of community college. This plan will largely be paid for by increasing the tax rate of the highest income bracket, capital gains tax increases on higher-income taxpayers, and other provisions aimed at closing the “tax gap.”
During the last week of May 2021, the White House released the proposed federal budget for fiscal year 2022. The budget proposal focuses on the two major legislative proposals above. This budget proposes several tax reforms with the goal of modernizing the U.S. tax system by raising revenue, making the Internal Revenue Code more equitable and efficient, and improving tax compliance. Below, we provide a brief summary of provisions that are likely to effect high-income individuals who also own interests in businesses.
Provisions Related to High-Income Individuals
- The Biden administration has proposed increasing the top marginal tax rate from 37% to 39.6% for tax years beginning after December 31, 2021. The proposal also includes compressing the other rates, so that the top marginal rate starts at a lower level of taxable income than it currently does. This effectively reverses the tax cut created by the 2017 federal tax reform act. The proposed rate increase would apply in the 2022 tax year to taxable income over $509,300 for married individuals filing a joint return, $452,700 for unmarried tax filers (not including surviving spouses), $481,000 for head-of-household filers, and $254,650 for married individuals filing separate returns.
- The administration has proposed increasing the long-term capital gains rate from 20% to 39.6% for taxpayers whose adjusted gross income exceeds $1 million. For married taxpayers who file separately, the threshold is $500,000. These adjusted gross income limits will be indexed annually for inflation after 2022. The president’s proposal to increase capital gains tax rates is proposed “for gains required to be recognized after the date of announcement.” Biden administration officials have indicated that the “date of announcement” would be April 28, 2021, the date the president announced his American Families Plan. Some commentators think it may be a reference to May 28, 2021, the date the Green Book was released. It is important to note that the administration cannot set the effective date for legislation. That date will be determined by Congress when the legislation is drafted, so we will have to wait and see what happens with this proposal.
- The Biden administration has also proposed the taxation of previously untaxed transfers of appreciated property, if the transfer is made by gift during the owner’s lifetime, or on the death of the owner. This proposal will have a significant impact on income tax, wealth, and philanthropic planning. The proposal would be effective after December 31, 2021, for gains on property transferred by gift, and on property owned by decedents dying in 2022 and later. Under this proposal, transferred property is treated as if it had been sold, the gain realized, and the tax calculated on the realized gain. The recipient will receive the property with the fair market value that was used to calculate the gain to the donor or decedent. The donor or the decedent’s estate will be responsible for the payment of the taxes.
As of now, it appears that capital loss carryforwards from prior years, and capital losses generated from other transactions in the same year, may be utilized to offset these gains. Any taxes imposed by this proposal on gains at death would be deductible on the decedent’s estate tax return. The realized gain would be taxed at capital gains rates, subject to several exclusions and limitations. Some of these are:
- A $1 million per-person exclusion from recognition of unrealized capital gains on property transferred by gift or held at death. This would allow for an exclusion of $2 million per married couple. Any unused portion of the exclusion would be portable to the decedent’s surviving spouse. The exclusion amount will be indexed for inflation starting in 2023.
- For sales of residences, the current $250,000 per-person exclusion ($500,000 per married couple) for capital gains on the sale of a principal residence would also apply to the sale of all residences owned by the taxpayer. It also would be portable to the surviving spouse.
- The current capital gain exclusion on certain small business stock apparently will continue to apply. More guidance will be needed regarding this.
- Certain transfers to a U.S. spouse or to a charity would not create a recognition event. The spouse or charity would receive a carryover basis. When the U.S. spouse disposes of the asset, or dies, the capital gain will be recognized at that time.
- Transfers of personal property that have appreciated in value would be excluded from this gain recognition. This would include household furnishings and personal effects, but not collectibles.
Elimination of the Preferential Treatment of Certain Gains on Like-Kind Exchanges
- The Biden administration has proposed taxing any gains in excess of $500,000 in aggregate per taxpayer from like-kind exchanges of real property during any tax year. This limit is a per-taxpayer limit. Thus the annual limit for a married couple filing a joint return would be $1 million. Any gains from like-kind exchanges of more than $500,000 ($1 million for married couples filing a joint return) would be recognized by the taxpayer in the year the taxpayer transfers the real property.
- This proposal would be effective for exchanges completed in tax years beginning after December 31, 2021. This effective date appears to indicate that taxpayers who participate in a like-kind exchange during the latter half of the 2021 year may need to complete the second half of the like-kind exchange before December 31, 2021, or risk possible taxation of part of their gain (if it is over the $500,000/$1 million limit), even though the 180-day period does not lapse until sometime in 2022.
Carried Interest Changes for Partnerships
Some quick background on this concept: Partners generally receive partnership interests in exchange for contributions of cash and/or property. They may also receive partnership interests—usually for future partnership profits—in exchange for services to be performed for the partnership. This type of partnership interest may be referred to as a “carried interest” or “profits interest.” Income attributable to a profits interest is generally subject to self-employment tax, unless the income generated by the partnership is a type not subject to self-employment tax—i.e., capital gains, interest and dividend income, and certain rental income.
The Biden administration has indicated that they believe income from an investment partnership that is attributable to a partner’s carried interest should be taxed as ordinary income and subject to self-employment tax because the income is related to the performance of services by the partner. The Biden administration proposes to tax this as ordinary income, regardless of the nature of the income at the partnership level (interest income, dividends, capital gains, rental income, etc.), if the partner’s taxable income exceeds $400,000. The income would also be subject to self-employment tax. Gain recognized on the sale of the carried interest would also be taxed as ordinary income, for taxpayers with taxable income above $400,000. There are some exceptions to this proposed rule, and there is a specific definition regarding investment partnerships that taxpayers will need to explore in more detail with their tax advisor to determine if this proposal is applicable to them.
Provisions Related to Flow-Through Entities
- Transfers of Appreciated Property – The Biden administration’s proposal includes the following statement: “Transfers of property into, and the distribution of property in kind from a trust, partnership, or other non-corporate entity, other than a grantor trust that is deemed to be wholly owned and revocable by the donor, would be recognition events.” It appears that the provision is intended to apply only when the contribution or distribution would result in a gift under the gift and estate tax provisions. Additional clarification and guidance will be needed on this proposal. Entities to which this proposal may apply should seek additional information regarding the timing and rules as they apply to their situation.
- 90-Year Assets – This proposal from the Biden administration would require the unrealized gain in assets owned by a partnership, trust, or other non-corporate entity to be recognized if the property has not had a recognition event within the previous 90 years. This provision could have a significant impact on family-held assets that have been passed from generation to generation within an entity. It is unclear if the proposal would require the recognition of an asset’s unrealized appreciation that has not been the subject of a recognition event within the prior 90 years regardless of when the entity acquired the asset. We will have to see if there are any exemptions or exclusions to the gain recognition provisions applicable to gifts or bequests. Also, we will want to see if there will be any provisions to allow for a multiyear payment of any tax. For entities with illiquid assets, it could force the sale of the assets if the tax must be paid in the year of recognition.
Testing for the 90-year holding period would be for periods beginning January 1, 1940. Thus, if this is applicable to any long-held assets held in a flow-through entity, a recognition event would not happen until December 31, 2030, when the 90-year holding period is reached.
- Net Investment Income Tax (NIIT) and Self-Employment Contributions Act (SECA) – In order to ensure that all flow-through business income of high-income taxpayers is subject to either the NIIT or SECA taxes, the Biden administration has proposed the following changes:
- Subject all trade or business income of high-income taxpayers to the 3.8% Medicare tax, either through the NIIT or SECA tax, by broadening the definition of net investment income to include income and gain from any trades or business that is not otherwise subject to the employment taxes. For this purpose, high-income taxpayers are individuals with adjusted gross income of more than $400,000.
- Impose SECA tax on partners’, members’, and shareholders’ distributive shares of partnership, LLC, or S Corporation business income if they materially participate in the business and they provide services, to the extent that this flow-through income exceeds certain threshold amounts.
- These changes would be effective for tax years beginning after December 31, 2021.
Provisions Related to Corporate Taxation
- The federal income tax rate for corporations is proposed to increase from 21% to 28%. This change would be applicable to tax years beginning after 2021. Because corporations can have fiscal years, a blended rate would apply to fiscal tax years that begin in 2021 and end in 2022.
- The Biden administration also proposes a 15% minimum tax on worldwide book income for corporations with income of more than $2 billion.
- There are also several proposals to reform the U.S international tax system. A discussion of these proposals is beyond the scope of this summary.
Provisions Related to Compliance and Tax Administration
The Biden administration’s proposal provides for additional funds for the IRS to increase compliance and address noncompliance, including regulating tax return preparers and enhancing the accuracy of tax information. Additional resources will be focused on enforcement of taxpayers with income above $400,000. The goal is to close the “tax-gap”—the difference between what should have been collected in a year and what was collected.
The Biden administration also has proposals to create comprehensive financial account reporting rules. Financial institutions would be required to report additional, more-detailed data on financial accounts in an information return. Similar reporting requirements would be applicable for crypto asset custodians and exchanges.
Additional clarification is needed on many of these provisions. Keep in mind that these are the initial proposals, and that the legislative process still needs to take place. Taxpayers would be wise to keep their eyes on the tax legislative process as it moves along throughout the rest of this year, since several tax-planning opportunities may be available before the end of the year.
The state income tax impact of some of the proposed changes will depend on how the gain recognition on assets is determined for federal income tax purposes in the final legislation. For individual income tax returns, most states utilize federal taxable income or federal adjusted gross income as the starting point for calculating state taxable income. If the proposed federal changes are included in the state’s tax law by conformity to the federal law, or adoption of federal provisions, state tax liabilities will be increasing as well.
This article was originally drafted in mid-June 2021. Congress has been working on drafting the bills to create the legislation that will put these proposals into law. During the legislative process, changes and/or modifications will likely occur. We will have a follow-up article on the outcome and the impact of the newly enacted tax laws.
Susan Lash, CPA
Disclosure: The opinions expressed are those of Running Point Capital Advisors, LLC (Running Point) and are subject to change without notice. This is not an offer to buy or sell or a security or a recommendation to buy or sell a security. Forward looking statements cannot be guaranteed. Running Point is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Running Point’s investment advisory services and fees can be found in its Form ADV Part 2, which is available upon request. RP-21-18