The White House and Treasury today released the Fiscal Year 2022 Federal Budget and the Treasury Green Book, which include new details regarding the Biden administration's American Families Plan and proposed 2021 tax changes – including a proposed retroactive capital gains tax increase to 37 percent to the extent household adjusted gross income exceeds $1 million. The tax changes expected to be enacted this year could be substantial and far-reaching and include corporate, individual and capital gains tax rate increases; international tax changes; and estate and gift tax changes.
The Treasury Green Book proposes to raise $2.4 trillion in revenue from the proposed tax changes. It also proposes significantly increasing IRS resources and staffing and estimates that over $700 billion of federal revenue would be generated from increased information reporting and tougher and more comprehensive tax enforcement.
Expected Timing of Biden Administration Tax Changes
Congressional committees in the House and Senate will soon begin working on tax and budget proposals that will become part of the next budget reconciliation bill. The House and then the Senate will craft and approve a budget resolution to serve as the vehicle for the reconciliation process. Many expect committee action to begin in the coming weeks, with ultimate enactment of a comprehensive, single package in the fall. Only 51 votes are needed to pass budget reconciliation legislation in the Senate. The effective dates of the newly enacted provisions generally are expected to be Jan. 1, 2022, but certain provisions may have proposed effective dates tied to announcement, committee action or the date of enactment. For example, capital gains tax rate increases have been proposed by the Biden administration to apply to "gains required to be recognized after the date of announcement [presumably late April 2021]," and may be proposed by congressional committees to apply to sales occurring after the date of announcement, congressional committee action or the date of enactment of the legislation later in the fall. Historically, proposed effective dates for capital gains increases often have slipped to date of enactment of the legislation. We expect the same to occur this year. The effective dates of certain provisions may be phased in over time, and certain provisions may be enacted on a temporary rather than permanent basis to help keep the scored cost of the legislation within acceptable parameters.
Depending on a taxpayer's specific circumstances, significant tax savings may be achieved by those who anticipate the expected changes and take steps now to take advantage of existing tax provisions and rates. This alert addresses only a fraction of the tax changes expected to be enacted this fall; additional details will be released over time as congressional proposals take the form of draft legislation.
Expected Corporate Tax Rate Increases and Related Changes
Corporate tax rates are proposed by the Biden administration to increase from 21 percent to 28 percent. Most believe the corporate rate will actually increase to no more than 25 percent. For noncorporate taxpayers, it is unclear whether the Section 199A 20 percent pass-through deduction will become unavailable or be changed or reduced. The Joint Committee on Taxation estimates the calendar year 2020 tax savings from Section 199A to be nearly $50 billion. The Green Book is silent on Section 199A, but President Biden campaigned on limiting the Section 199A pass-through tax deduction for high-income taxpayers (households earning in excess of $400,000). Senate Finance Committee Democrat staff are working on a series of changes that would eliminate Section 199A benefits for high-income taxpayers. Section 199A already is unavailable to certain individuals in certain services businesses (including lawyers and doctors and certain businesses with insignificant numbers of employees and few assets) earning in excess of $164,900 ($329,800 for joint filers). The Green Book also is silent regarding net operating loss (NOL) carrybacks. 2021 tax reform legislation nevertheless is expected to prohibit NOL carrybacks for tax returns not filed by the date of enactment. The American Families Plan states that it will "permanently extend the current limitation in place that restricts large, excess business losses." Internal Revenue Code Section 162(l) generally disallows use of noncorporate losses in excess of $250,000 ($500,000 for joint filers). The CARES Act removed the Section 461(l) limitation for tax years 2018-2020. The American Rescue Plan Act of 2021 (ARPA) pushed out the current expiration of Section 461(l) from 2026 to 2027. The ARPA did not remove or change CARES Act provisions relating to Section 461(l). The Green Book proposes to permanently extend Section 162(l), effective for taxable years beginning after Dec. 31, 2026.
The Biden administration also is proposing:
- For the global intangible low-taxed income (GILTI) regime:
- Eliminating the exemption from GILTI for the 10 percent return on foreign tangible property (referred to as qualified business asset income or QBAI).
- Doubling the GILTI tax rate from 10.5 percent to 21 percent.
- Imposing a country-by-country method for calculating GILTI (thus eliminating the ability to blend high-taxed GILTI against low-taxed GILTI).
- Repealing the high-tax exemption to subpart F income and the cross-referencing to it in the GILTI rules.
- Limiting the ability of a domestic corporation to expatriate by lowering the threshold for continuing former shareholder ownership to at least 50 percent (rather than at least 80 percent) under the inversion rules of Section 7874. And regardless of shareholder ownership, proposing to find an inversion transaction where (1) the domestic entity has a greater fair market value than the foreign acquirer, (2) the group is primarily managed and controlled from within the United States and (3) the group does not conduct substantial business activities in the country in which the foreign acquirer is organized.
- Repealing the foreign-derived intangible income (FDII) regime that provides a deduction to domestic corporations regarding their intangible income earned from serving foreign markets, and replacing it with additional research and development credits.
- Replacing the base-erosion and anti-abuse tax (BEAT) with a
so-called stopping harmful inversions and ending low-tax
developments (SHIELD) proposal. SHIELD generally would deny tax
deductions for certain related-party payments where the recipient
is in a low-tax jurisdiction (i.e., a jurisdiction with a tax rate
below 15 percent).
- In tandem with this proposal, the United States is petitioning the OECD and G20 for an agreement on a global minimum corporate tax rate of 15 percent.
- Modifying the interest expense limitation rules under Section 163(j) by limiting the available deduction of a U.S. corporate group member to its proportionate share of the financial reporting group's net interest expense.
- Adding a 15 percent so-called minimum tax on corporations with more than $2 billion of "book income."
- Creating a new business credit equal to 10 percent of certain eligible expenses associated with onshoring jobs and investments into the United States.
- Imposing an "offshoring penalty" surtax on U.S. company offshore production profits for sales back into the United States (10 percent surtax leading to a 30.8 percent effective tax rate; it would also apply, for example, to offshore services or call centers serving the United States).
- Providing or expanding tax credits and incentives for manufacturing, renewable energy, alternative fuels, carbon capture and small businesses.
- Repealing fossil fuel tax preferences.
- Eliminating deductions for consumer drug advertising.
- Repealing bonus depreciation, including repealing the increase in bonus depreciation from 50 percent to 100 percent.
Details of these proposals are still being refined, and certain of these proposals may be difficult to draft or administer. Others may be enacted only in part. All the proposals are relevant in the sense that they provide insight into what the Biden administration is hoping to achieve.
Changes in Social Security taxes, the minimum wage, and many other Biden administration or congressional proposals do not qualify for consideration as part of budget reconciliation legislation. Somewhat surprisingly, Treasury's 2021 Green Book contained almost none of the corporate tax changes proposed in the Obama administration's fiscal 2017 budget, released on Feb. 9, 2016. That Obama administration budget included more than 140 tax proposals, including a repeal of the last-in, first-out (LIFO) method of accounting for inventories. A copy of that 2016 Democrat Treasury Green Book is available here. We expect Congress to propose to enact certain revenue raisers from the 2016 Green Book.
Expected Changes to Existing Timeline for Certain Tax Cuts and Jobs Act Provisions
Many of the provisions of the 2017 Tax Cuts and Jobs Act (TCJA) that currently are scheduled to change or expire in the coming years will be addressed in the budget reconciliation package this fall and, as a result, may change or expire earlier than previously provided. The larger standard deduction, the Section 199A deduction and many other provisions of the TCJA currently are scheduled to expire at the end of 2025.
Expected Capital Gains and Dividend Tax Rate Increases for Higher-Income Individuals
Capital gains and dividend tax rates are proposed to increase for certain higher-income taxpayers from their current level of 23.8 percent (a 20 percent tax rate plus the 3.8 percent tax on net investment income) to 40.8 percent (a 37 percent capital gains rate plus the 3.8 percent tax on net investment income). The higher rates are proposed to apply "to the extent that the taxpayer's income exceeds $1 million ($500,000 for married filing separately)." The Biden administration proposal would tax higher-income individual taxpayers on their long-term capital gains and qualified dividends at 37 percent, and on short-term capital gains and ordinary dividends at an ordinary rate of 39.6 percent. It appears that a number of senators may be uncomfortable with capital gains rates in excess of 28 percent (31.8 percent once you add the 3.8 percent tax on net investment income); for now, taxpayers should anticipate at least a nominal increase of 8 percentage points (8/20=40 percent; 8/23.8=33.6 percent), or effectively a 33.6 percent increase in capital gains rates. The Biden administration has proposed that the capital gains tax increase apply to "gains required to be recognized after the date of announcement [presumably late April 2021]." Most expect congressional committees will propose that increased capital gains rates apply at some date in 2021 tied to announcement, congressional committee action or date of enactment. Most also believe, based on history, that those effective dates may slip and ultimately may apply to sales occurring on or after the date of enactment of the legislation. We anticipate a single, substantial tax reform package to be enacted sometime in the last calendar quarter of 2021. We also expect capital gains tax increases will apply to gains recognized after the date of enactment.
As discussed further below, the Biden administration also has proposed that capital gains would be recognized upon the occurrence of certain events, including gifts, deaths and other transfers.
End of S Corporation/'Active Income' Medicare Tax Loophole
The Green Book explains that high-income (generally those earning more than $250,000 for joint filers) workers and investors generally pay a 3.8 percent tax on net investment income, and a 3.8 percent Medicare tax (2.9 percent plus an additional 0.9 percent on wages over $250,000 for joint filers) on employment earnings. Application of these taxes is inconsistent across taxpayers, which the Biden administration states is "unfair ... and provides opportunities ... for those with high incomes to avoid paying their fair share of taxes." The Biden administration proposes that all such taxes apply consistently to those making over $400,000. Specifically, the definition of net investment income would include gross income and gain "from any trades or businesses that is not otherwise subject to employment taxes," and certain partnership income and S corporation income would be subject to employment taxes (and therefore to the Medicare tax).
Expected Carried Interest and Like-Kind Exchange Changes
Profits from carried interest are further targeted for taxation at ordinary income tax rates by a Biden administration proposal to eliminate the application of Section 1061 for taxpayers with taxable income in excess of $400,000 and to taxing as ordinary income those partners' share of income from an "investment services partnership interest" in an investment partnership to which they provide services. Such income also would be subject to self-employment taxes.
The like-kind exchange rules are proposed to be repealed for gains during a taxable year greater than $500,000 ($1 million for joint filers). The Green Book proposed effective date of like-kind exchange repeal is for "exchanges completed in taxable years beginning after December 31, 2021." We expect taxpayers to lobby for helpful transition rules for sales under binding contracts or sales completed before the date of enactment where title to qualified replacement property is obtained after date of enactment.
Expected Individual Income Tax Rate Increases and Changes
For individuals (including households of joint filers) earning more than $452,700 in a calendar year ($509,300 for joint filers), the Green Book proposes to increase the top marginal income tax rate from its current level of 37 percent to the pre-2018 level of 39.6 percent. The Section 199A pass-through deduction, which allows certain pass-through business owners to deduct up to 20 percent of their qualified business income (leading to a current-law marginal rate of 29.6 percent), is not proposed to be changed by the Green Book, but is expected to be repealed or carved back by Congress for taxpayers with adjusted gross income in excess of $400,000.
The $10,000 cap on state and local tax (SALT) deductions may be repealed and replaced by Congress with limitations on itemized deductions (i.e., phaseouts, a 28 percent cap on the value of itemized deductions, etc.) for taxpayers earning in excess of $400,000. The outright repeal of the SALT cap is expected to cost the government in excess of $600 billion over 10 years. The Green Book is silent on the SALT cap; views in Congress vary widely among members.
Expected Estate and Gift Tax Increases and Changes
The estate tax and lifetime gift tax exemption (which was temporarily doubled until 2025) is currently $11.7 million per person ($23.4 million for married couples). In addition, there is a $15,000 per donee gift tax exclusion ($30,000 if spouses agree). The current estate tax rate on amounts in excess of the exemption amounts is a flat 40 percent, and the tax basis in inherited assets is "stepped up" to the fair market value upon the death of the decedent. President Biden stated during the presidential campaign that he would seek an increase in the estate tax rate to 45 percent and a reduction in the exemption amounts to their pre-TCJA level ($5.3 million per person, $10.6 million for married couples). The Green Book is silent regarding these expected changes (which are still expected to be enacted this year) and focuses on recognition of gains upon several defined events – a substantial departure from current law. Specifically, the donor of an appreciated asset generally would recognize capital gains at the time of a gift in the amount of the excess of the fair market value of the asset as of the date of the gift over the donor's basis in such asset. Likewise, the estate of a decedent generally would recognize capital gains on appreciated assets at death. The recipient's basis in property received by reason of the decedent's death would be stepped up to the fair market value as of the decedent's date of death. Such gain would be taxable income to the decedent on his or her federal gift or estate tax return or on a separate capital gains return. Assets transferred by a donor or a decedent to a U.S. spouse or a charitable organization would retain a carryover basis, and a charity generally could dispose of such property without being taxed on the gain. The use of capital losses and carry-forwards from transfers at death would be allowed against capital gains income and up to $3,000 of ordinary income on the decedent's final income tax return, and the tax paid would be deductible on the estate tax return of the decedent's estate.
A $1,000,000 per-person ($2,000,000 per married couple) exclusion from recognition of unrealized capital gains on property transferred by gift or held at death, indexed for inflation after 2022, would be allowed and would be portable to a decedent's surviving spouse. The American Families Plan also provides that the payment of tax on the appreciation of certain family-owned businesses would not be due until the interest in the business is sold or the business ceases to be family owned. The proposal would allow a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets.
Many Democrat members of the House and of the Senate are expected to withhold their support for the imposition of capital gains taxes at death. Democrats generally seem supportive of imposing carryover basis at death.
In addition to recognition of gain upon gifts and death, the Green Book describes other transfer events that would trigger a capital gains tax. These events include transfers of an appreciated asset to or from a trust, partnership or other noncorporate entity (other than a grantor trust that is deemed to be wholly owned and revocable by the donor). Similarly, transfers out of a revocable grantor trust would be a recognition event to the extent such transfer is to someone other than (i) the deemed owner, (ii) the U.S. spouse of the deemed owner or (iii) a distribution made in discharge of an obligation of the deemed owner. Current law deems many of these transfers as nonrecognition events; thus, the proposed new changes would cause more frequent taxation of asset appreciation and make it much more difficult and expensive to transfer assets to heirs.
The aforementioned proposals are proposed by the Green Book to be effective for gains on property transferred and on property owned at death by decedents dying after Dec. 31, 2021.
The portability of exemption amounts between spouses generally is expected to continue, but many other planning techniques (including valuation discounts obtained in related-party transactions) presently utilized by taxpayers are proposed to be curtailed. While it is worth noting that (i) the Tax Reform Act of 1976 would have imposed carryover basis on inherited assets, that provision was repealed before it could ever take effect, and (ii) the Economic Growth and Tax Relief Reconciliation Act of 2001 repealed the estate tax and curtailed step-up in basis, but only for one year (2010), Treasury Secretary Janet Yellen has stated that elimination of the step-up in asset basis at death is a priority for the Biden administration.
Securing a Strong Retirement Act's Proposed Changes to Retirement Plans
On May 5, 2021, the House Ways and Means Committee voted unanimously to send the Securing a Strong Retirement Act to the full House for consideration. The proposed legislation aims to increase retirement savings and simplify retirement plans with changes that include:
- Requiring automatic enrollment for 401(k) and 403(b) plans. Initial automatic enrollment must be at least 3 percent of pay, with 1 percent increases each year up to at least 10 percent. Participants may opt out at any point. The proposed legislation exempts existing plans in some cases, SIMPLE 401(k) plans, small businesses with 10 or fewer employees, and new businesses.
- Increasing the mandatory-distribution age for retirement plans from 72 to 73 in 2022, to 74 in 2029 and to 75 in 2032.
- Increasing the catch-up contribution limit for individuals age 62 to 64 from $6,500 to $10,000 for non-SIMPLE plans and from $3,000 to $5,000 for SIMPLE plans. Both limits would be indexed with the cost of living.
- Requiring qualified plans, as well as 403(b) and 457(b) plans, to designate catch-up contributions as Roth contributions.
- Allowing qualified plans, as well as 403(b) and 457(b) plans, to provide participants with the option of treating matching contributions as Roth contributions.
- Allowing plans to treat student-loan payments as elective deferrals for the purpose of making matching contributions under 401(k), 403(b), SIMPLE IRA and 457(b) plans.
- Reducing the waiting time before plans are required to allow long-term, part-time workers into 401(k) plans from three consecutive years of service to two.
The bill also reduces required notices to unenrolled retirement plan participants and makes other changes aimed at increasing retirement savings and simplifying retirement plan administration.
Two senators – one Republican and one Democrat – have introduced a comparable bill in the Senate. The Senate bill has not yet gone through committee, and it differs from the House bill. A few key differences are that the Senate proposed legislation would (i) not require automatic enrollment; (ii) increase the mandatory-distribution age only once, to 75 in 2032; and (iii) increase the catch-up limits at age 60 (rather than at age 62).
This bipartisan legislation previously was introduced in 2019. We expect this legislation to be included in the fall 2021 budget reconciliation bill or otherwise enacted within the next year or so.
Expected Additional Clarifications, Details and Changes
As the administration and congressional committees continue to work on tax and budget proposals, clarifications and details regarding the various proposals will emerge. Some of the initial proposals may be abandoned and revised, and additional proposals may emerge. As noted above, depending on a taxpayer's specific facts and circumstances, significant tax savings may be achieved by taxpayers who anticipate expected tax changes and take steps regarding their business plans, transaction pipelines, restructurings, operational affairs and estate plans in a manner that takes advantage of current tax provisions.
BakerHostetler will continue to keep our clients and friends updated on these developments.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.