Now that the new administration has started to outline some of its key proposals, we want to tell you about some of those proposals that are tax-specific in nature. Shortly after the election, we wrote about some of then President-Elect Biden’s tax plans. With more detail now being formed around those early campaign proposals, let’s go over how they might affect you.
While we can’t predict the final changes to the tax code with certainty, the Biden-Harris administration has now clearly outlined its revenue proposals. Most of of these tax proposals are targeted to be effective for tax year 2022. The Department of the Treasury published the “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals”, the so called “green book”, in May.
Key Tax Proposals of the American Jobs Plan and the American Families Plan
- Reform Corporate Taxation
- Raise flat federal tax rate from 21% to 28% for C corporations
- Impose minimum 15% tax rate on “book” earnings of large corporations
- Support Housing and Infrastructure
- Expand low income housing tax credits
- Prioritize Clean Energy
- Eliminate fossil fuel tax credits
- Provide tax credits for clean energy and electric vehicle-related activities
- Strengthen Taxation of High-Income Taxpayers
- Increase the top marginal tax rate
- Reform taxation of capital gains
- Revise the net investment income tax and self employment taxes
- Support Workers, Families and Economic Security
- Permanently expand earned income tax credit
- Extend and expand child and dependent care credits
- Close Loopholes
- Eliminate like-kind exchanges
- Improve Compliance
- Provide additional IRS funding
- Improve Tax Administration
- Increase oversight of paid preparers
- Expand crypto asset compliance
In this article, we will be focusing on the area emphasized above – “Strengthen Taxation of High-Income Taxpayers” under the American Families Plan.
There are three key sections under this aspect of the Biden-Harris administration’s tax proposals:
- Increase the top marginal tax rate
- Reform taxation of capital gains
- Revise the net investment income tax and self employment taxes
Increase the top marginal tax rate
The first key section within this area of the American Families Plan is pretty straight forward – increase the top marginal income tax rate from the current 37% for married couples earning over $628,300 to 39.6% for married couples earning over $509,300. This represents a direct reversal from the reform enacted under the previous administration.
While a 2.6% increase obviously raises taxes for high-income earners, this proposal includes another, less obvious tax hike. Reducing the threshold where higher rates become effective would subject many taxpayers to significantly higher increases in their tax rate.
Take, for example, a married couple earning a combined $510,000/year. Under current tax law, this couple would be in the 35% tax bracket; under this proposal, however, that same couple would be in the 39.6% tax bracket. This represents an effective increase in their marginal tax rate of 4.6%.
Reform taxation of capital gains
The next key area under the plan is to reform the taxation of capital income (capital gains). This one is a bit more complicated.
Under current law, tax rates on long-term capital gains (from sales of assets held longer than a year) vary. The highest rate applied to this type of income is 20% (23.8% including any applicable net investment income tax). A 15% rate or even a 0% rate applies to taxpayers in the lower tax brackets.
Moreover, capital gains are only taxed upon recognition, such as the sale or other disposition of an appreciated asset. When a donor gives an appreciated asset to a donee during the donor’s life, the donee’s basis in the asset is the basis of the donor; in effect, the basis is “carried over” from the donor to the donee. There is no recognition of capital gain at the time of the gift by either the donor or the donee. Instead, the donee would recognize capital gain (or loss) at the time of the donee’s later disposition of the asset.
When an appreciated asset is held by a decedent at death, the basis of the asset for the decedent’s heir is adjusted (usually “stepped up”) to the fair market value of the asset at the date of the decedent’s death. As a result, any appreciation during the decedent’s life on assets that are still held by the decedent at death avoids federal income tax.
Reasons for change
The Biden-Harris plan states that preferential tax rates on long-term capital gains and qualified dividends disproportionately benefit high-income taxpayers. It points out that current law affords many high-income taxpayers a lower overall tax rate than low and middle-income taxpayers. This is because income for low and middle-income taxpayers consists primarily of traditional earnings, subject to ordinary tax rates; income of high-income taxpayers, on the other hand, traditionally consists of more investment income that qualifies for these lower rates. Additionally, they claim that the rate disparity between ordinary income and long-term capital gains encourages efforts to convert labor income into capital income as a tax avoidance strategy.
Because current law allows a taxpayer who inherits an appreciated asset to receive a stepped-up basis in that asset equal to the asset’s fair market value at the time of the decedent’s death, appreciation that occurred during the decedent’s life is never subjected to income tax. In contrast, less-wealthy individuals typically spend down their assets during retirement, forcing them to recognize the capital gains. This further increases the inequity in the tax treatment of capital gains. In addition, the preferential treatment for assets held until death can produce an incentive for taxpayers to lock in portfolios of assets and hold them for the purpose of avoiding capital gains tax on the appreciation. The administration argues that, otherwise, these taxpayers would reinvest the capital in more economically productive investments.
Tax capital income for high-income earners at ordinary tax rates.
“Long-term capital gains and qualified dividends of taxpayers with adjusted gross income of more than $1 million would be taxed at ordinary income tax rates”. This would mean that the highest rate, generally 39.6% (43.4% including the net investment income tax) would apply to long-term capital gains, but only to the extent that the taxpayer’s income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022.
This proposal would be effective for gains required to be recognized after “the date of announcement,” (presumably late April 2021). This date would be highly contested, however, as it would effectively represent a retroactive tax increase if passed.
Treat transfers of appreciated property by gift or on death as recognition events.
Under the proposal, the donor or deceased owner of appreciated assets would recognize capital gains at the time of transfer.
For a donor, the amount of the gain realized would be the excess of fair market value on the date of the gift over the donor’s basis in that asset. For a decedent, the amount of gain would be the excess of fair market value on the decedent’s date of death over the decedent’s basis in that asset. That gain would be taxable income to the donor/decedent on “the Federal gift or estate tax return or on a separate capital gains return.”
The gift and estate tax provisions would define a transfer and the methodologies for valuing assets.
Transfers by a decedent to a spouse or to charity would continue to carry over the decedent’s basis. Surviving spouses would not recognize gain until disposition of the asset or death; charities would not recognize any taxable gain on transfers of appreciated property.
This proposal would subject gains on property transferred by gift or death after December 31, 2021 to these new rules.
Revise the net investment income tax and self-employment taxes
The last component within this key area relates to a revision of the net investment income tax and self-employment taxes.
Under current law, individuals with incomes over a threshold amount ($200,000 for single and head of household filers; $250,000 for joint filers) are subject to an additional 3.8% tax on net investment income (NII). NII generally includes: (1) interest, dividends, rents, annuities, and royalties, unless derived in the ordinary course of business; (2) income derived from business in which the taxpayer does not materially participate; (3) income from a business of trading in financial instruments or commodities; and (4) gain from the disposition of property not held in a business in which the taxpayer materially participates.
Self-employment income, like wages from employment, is subject to employment taxes. The Self-Employment Contributions Act (SECA) applies to self-employment income, similar to the Federal Insurance Contributions Act (FICA) that applies to wages. Both SECA and FICA taxes have two components:12.4% for social security tax (capped at $142,800 in 2021) and 2.9% for Medicare tax (not subject to a cap). An additional 0.9% Medicare tax applies to both self-employment and employment earnings of high-income taxpayers, above the same NIIT thresholds.
General partners and sole proprietors pay SECA tax on their entire net business income, subject to certain exceptions. Limited partners are statutorily excluded, under Section 1402(a)(13) of the Internal Revenue Code, from paying SECA tax on their distributive share of partnership income or loss; they are, however, subject to SECA tax on their payments for services they provide to the partnership.
S corporation shareholders are not subject to SECA tax. However, owner-employees must pay themselves “reasonable compensation” for services provided. On this compensation, they pay FICA tax like any other employee. Nonwage distributions to shareholders of S corporations are not subject to either FICA or SECA taxes.
Reasons for Change
Business owners receive inconsistent treatment for purposes of the NIIT and SECA tax, depending on the legal form of ownership. While some pay SECA tax on all business earnings, others pay employment taxes on only a portion of their earnings.
LLC members often pay little or no SECA tax at all. Although the NIIT reflects an intention to impose the 3.8% tax on all income of high-income taxpayers, certain income still escapes both SECA tax and the NIIT. Examples of this include the distributive share of income of S corporation shareholder-employees, limited partners, and some LLC members. The administration asserts this inconsistent treatment is unfair and provides planning opportunities to avoid paying all employment taxes.
The current system is also a challenge for the Internal Revenue Service (IRS) to administer. The determination of “reasonable compensation” of S corporation owners generally depends on facts and circumstances and requires a valuation analysis. These are expensive and can be contested by the taxpayer, adding to the cost of administration and enforcement. Uncertainty surrounding treatment of some limited partners and LLC members also undermines the IRS in ensuring payment of these taxes
In addition, the General Fund of the Treasury receives proceeds from the NIIT, while the Hospital Insurance Trust Fund receives proceeds from the Medicare portion of FICA and SECA taxes. This treatment is inconsistent with the fact that both taxes are intended for the same purpose.
The proposals for addressing these identified issues include 4 things:
1. Ensure that all pass-through business income of high-income taxpayers is subject to either the NIIT or SECA tax
This would ensure that all business income of high-income taxpayers is subject to the 3.8% Medicare tax. The administration would accomplish this either through the NIIT or SECA tax (or a combination of both). In particular, for taxpayers with adjusted gross income in excess of $400,000, a revised definition of net investment income would include business income not otherwise subject to employment taxes.
2. Redirect NIIT funds to the Hospital Insurance Trust Fund
The Hospital Insurance Trust Fund would receive all revenue from the NIIT, similar to revenue under FICA and SECA.
3. Make the application of SECA to partnership and LLC income more consistent for high-income taxpayers
Materially participating limited partners and LLC members who provide services in their businesses would be subject to SECA tax on their distributive share of partnership or LLC income to the extent that this income exceeds certain threshold amounts. The exemptions provided for certain types of partnership income (rents, dividends, capital gains, etc.) would continue to apply.
4. Apply SECA to the ordinary business income of high-income non-passive S corporation owners
Lastly, materially participating S corporation owners would be subject to SECA taxes on their distributive share of the business income to the extent that this income exceeds certain threshold amounts. The exemptions provided for certain types of S corporation income (rents, dividends, capital gains, etc.) would continue to apply.
There will be a couple of steps to determine the amount of income subject to SECA tax under the proposal. First, materially participating partners/shareholders will have to calculate their SECA income. This would consist of: (a) ordinary business income from S corporations for which the owner materially participates in the business; plus (b) ordinary business income from limited partnerships or LLCs to the extent of material participation in these businesses. This sum is the “potential SECA income”.
Beginning in 2022, the additional income that would be subject to SECA tax would be the lesser of: (i) the potential SECA income; or (ii) the excess over $400,000 of the sum of the potential SECA income, wage income subject to FICA under current law, and 92.35% of self-employment income subject to SECA tax under current law. There would be no indexing for inflation on this $400,000 threshold amount.
Material participation standards would apply to individuals that have a direct or indirect ownership interest in a business. Taxpayers who are involved in a business in a regular, continuous, and substantial way are usually considered to materially participate. Often this means they work for the business for at least 500 hours per year. The statutory exception to SECA tax for limited partners would no longer apply if the limited partner otherwise materially participated.
In summary, the administration has laid out a revenue plan that will have direct implications to corporations and individual taxpayers alike. The tax proposals align with campaign promises to increase corporate tax rates and those on high income individual taxpayers. Transfer tax rules are also a focus; the recognition of gain on transfers by gift or death would be a substantive change in treatment. While some taxpayers have the potential to be impacted in 2021, all taxpayers should anticipate being impacted by some, if not many, of these new tax proposals by 2022.