When Tip O'Neill1 reigned in the House of Representatives, legislators served their constituents by ensuring that spending bills allocated money for projects in their communities. In the 21st century, however, partisan politics sometimes takes precedence over support for legislation containing significant financial support for popular local projects. Sometimes it appears that congresswomen and men are not paying attention to what is in the legislation. Well, your ever-vigilant Mayer Brown Tax Department has been paying attention to what the House Democrats accomplished on November 19, 2021. Specifically, they passed the 2,135-page Build Back Better Act (the "BBBA").2 This Legal Update examines the myriad proposed changes to the Internal Revenue Code (the "Code") contained in the BBBA, as passed by the House of Representatives.3
I. Individual Tax Changes
A. BUSINESS LOSSES
Code § 461(l), added by the Tax Cuts & Jobs Act (the "TCJA"), limits the ability of non-corporate taxpayers to claim excess business losses (i.e., business losses in excess of business income) in excess of $250,000 ($500,000 in the case of a joint return) against other types of income in any year. This limitation is scheduled to sunset after December 31, 2026. The BBBA would make it permanent. Furthermore, the BBBA would change how losses disallowed in the current year are treated in future years. Under current law, disallowed losses are carried forward as net operating losses, which can be used to offset income in future years without regard to Code § 461(l). Under the BBBA, disallowed losses would retain their character as excess business losses in future years and would be subject to the excess business loss limitation. The practical result of this change is that excess business losses that are disallowed under Code § 461(l) in a taxable year could also be limited in future taxable years.
B. STATE AND LOCAL TAX DEDUCTION
One of the more controversial provisions in the BBBA, which was not included in the Ways and Means Committee's prior version of the BBBA or the Biden administration's Green Book or BBBA framework, is a provision to increase the cap on deductions for state and local taxes (the "SALT deduction") beginning in 2021. It is expected that as the BBBA moves through the Senate, this is one provision that may change, particularly because certain Democratic senators have expressed concerns that the proposal disproportionately benefits high-income taxpayers.
Prior to the TCJA, individual taxpayers and non-grantor trusts and estates were allowed an itemized deduction for state and local real property and income taxes paid or accrued during the tax year. The TCJA imposed a $10,000 (joint filer) or $5,000 (married filing a separate return) limit on the SALT deduction through 2025.
The BBBA would extend the TCJA's temporary SALT deduction limitation through 2031 but would increase the limitation to $80,000 (joint filer) or $40,000 (estate, trust or married individual filing a separate return) for tax years 2021 through 2030. The limitation would revert to $10,000 (joint filer) or $5,000 (estate, trust or married individual filing a separate return) for tax year 2031. After December 31, 2031, the SALT deduction would not be subject to a limitation.
C. SOCIAL SECURITY TAXES/NET INVESTMENT INCOME
Under current law, S corporation members who materially participate in an S corporation's business are subject to self-employment tax only on "reasonable compensation" that they receive as employees. Similarly, limited partners who materially participate in a partnership's business are often not subject to selfemployment tax. Such individuals also are exempt from the 3.8% tax on net investment income under Code § 1411, which currently applies only to certain passive income and gains.
Beginning in 2022, the BBBA would expand the 3.8% net investment income tax to cover income derived in the ordinary course of a trade or business for taxpayers with incomes greater than $250,000 (married filing separate return), $500,000 (joint filer) or $400,000 (single filers) regardless of whether the taxpayer materially participates in such business. The proposal would clarify that net investment income does not include wages taken into account in determining self-employment income. The net investment income tax would have a phase-in threshold for taxpayers whose income does not exceed the threshold by more than $100,000. This provision is intended to ensure that individuals with interests in pass-through entities will be subject to the 3.8% net investment income tax or the self-employment tax on all income (whether wages, passive income or active business income) derived from such entities.
D. HIGH INCOME SURCHARGE
Beginning in 2022, the BBBA would impose a new 5% income tax surcharge on individuals, estates and nongrantor trusts with modified adjusted gross income above a certain threshold, which would apply in addition to any other applicable income tax. This new surcharge would apply to modified adjusted gross income in excess of $10 million for taxpayers who file as single, head of household or married filing jointly; $5 million for taxpayers who file married filing separately; and $200,000 for estates and trusts. An additional 3% income tax would be imposed on modified adjusted gross income in excess of $25 million for taxpayers who file as single, head of household or married filing jointly; $12.5 million for taxpayers who file married filing separately; and $500,000 for estates and trusts. For purposes of these proposed surcharges, a taxpayer's modified adjusted gross income would be adjusted gross income reduced by any deduction (other than "above-the-line" deductions) allowed for investment interest or business interest.
E. LIMITATION ON CERTAIN SPECIAL RULES FOR CODE § 1202 GAINS
Code § 1202 permits non-corporate holders of C corporation stock to exclude a certain percentage of the "eligible gain"4 from the sale of "qualified small business stock" held for more than five years. Generally, stock acquired after September 27, 2010, is eligible for a 100% gain exclusion.5 The BBBA modifies this rule so that any taxpayers with an adjusted gross income6 that equals or exceeds $400,000, as well as taxpayers that are trusts or estates, would only be permitted to exclude 50% irrespective of when a taxpayer acquired their qualified small business stock. For these taxpayers, this change reverts the Code § 1202 benefit to its state as originally enacted.7 This change would apply to sales or exchanges made on or after September 13, 2021, other than those for which a written binding contract was in effect prior to that date (as long as the contract is not materially modified after that date).
F. ACCELERATED DEDUCTIONS FOR LAWYERS WORKING IN CONTINGENCY FEE CASES
The BBBA would change the accounting for costs incurred by lawyers working contingency fee cases to allow them to immediately deduct costs paid or incurred by them in such litigations. Under current law, lawyers working on contingency-fee cases generally cannot deduct expenses incurred for depositions, expert testimony and discovery until the conclusion of the case. The BBBA would permit lawyers to currently deduct contingency-fee case expenses, even if there is a possibility that such expenses will be reimbursed by a court order or other award in a later year.
In contingency-fee arrangements, lawyers typically advance the costs of the litigation in return for a share of the client's eventual settlement or award. Current law suspends deductions for these expenses until the lawyer receives the corresponding income at the conclusion of the case or the case otherwise concludes. Current law puts significant pressure on class action lawyers to structure litigation funding as a non-taxable advance. The change provided by the BBBA should alleviate some of the pressure to structure litigation finance transactions as non-taxable forward contracts. The proposal would generally apply to amounts paid, incurred or received in tax years beginning in 2022 (the year after the date of the enactment of the BBBA).
II. Corporate Tax Changes
A. CORPORATE ALTERNATIVE MINIMUM TAX
The BBBA includes a new corporate alternative minimum tax ("Corporate AMT") based on income reported in the corporations' financial statements. Generally, the Corporate AMT would impose a 15% tax on certain corporations' adjusted financial statement income ("AFSI"). The tax is equal to the amount by which the corporation's "tentative minimum tax"—assessed at a 15% rate on its AFSI—exceeds its regular tax liability for the applicable tax year.
The Corporate AMT applies to an "applicable corporation," defined to be any corporation other than an S corporation, regulated investment company ("RIC") or real estate investment trust ("REIT") whose three-year average annual AFSI exceeds $1 billion (the "Income Test"). For purposes of the Income Test, the AFSI of a group of corporations under common control is aggregated, and, where the parent of the group is a non-US corporation, the group's three-year annual US-related AFSI (generally, the income of domestic members of the group and ECI of foreign corporations and all income of controlled foreign corporations ("CFCs") within the group) must also exceed $100 million. Once a corporation has met the Income Test in any year ending in 2022 or later, it continues to be an applicable corporation until (i) there is a change in ownership with respect to the corporation, (ii) there is a consistent reduction in AFSI below the relevant threshold or (iii) the Internal Revenue Service ("IRS") determines it would not be appropriate to continue to treat the corporation as an applicable corporation.
The calculation of a corporation's AFSI begins with the net income or loss reported on its "applicable financial statement" ("AFS"). An AFS includes a financial statement that is prepared in accordance with GAAP or IFRS used for reporting to a governmental agency such as the Securities and Exchange Commission ("SEC") or a foreign equivalent or that is used for reporting to owners, obtaining credit or another substantial nontax purpose if no financial statement is provided to a securities regulator. If the corporation reports income in a consolidated financial statement, the financial statement is treated as an AFS of the corporation. If it is part of a consolidated group, the AFSI of each member of the group is considered part of its AFSI. A corporation's AFSI includes its distributive share of profits and losses of partnerships in which it is a partner; the income of any disregarded entities owned by the corporation; and, if it is a US Shareholder of a CFC, its pro rata share of the AFCSI of the CFC. CFC losses may offset income of other CFCs, and be carried forward to offset CFC income in future years but not the AFSI of a US corporation. As with regular corporate income tax, AFSI may be reduced by financial statement net operating losses ("NOLs") not to exceed 80% of AFSI before accounting for such NOLs.
1 Thomas "Tip" O'Neill (D: Mass.) was the 47th Speaker of the House of Representatives from 1977 to 1987 and the author of a book using the same phrase as the title of our Legal Update. He served in the House from 1953 through 1987 and passed away in 1994.
2 HR 5376 (Rule Committee Print 117-18).
3 For our coverage of a prior iteration of this legislation, please see https://www.mayerbrown.com/en/perspectivesevents/publications/2021/09/overview-of-us-tax-provisions-of-build-back-legislation-approved-by-house-ways-means-committee
4 A taxpayer's "eligible gain" is generally the greater of (i) $10 million and (ii) 10 times the aggregate adjusted basis of the qualified small business stock issued by the corporation and disposed of by the taxpayer during the taxable year.
5 Eligible gain on qualified small business stock acquired after February 17, 2009, and before September 28, 2010, is eligible for a 75% exclusion, and stock acquired after August 10, 1993, and before February 18, 2009, is eligible for a 50% exclusion.
6 Determined without regard to Code §§ 1202, 911, 931 and 933.
7 The 75% and 100% exclusions were added to the Code in 2009 and 2010, respectively.
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