The House Ways and Means Committee released the most recent and most detailed picture of what tax reform may look like in support of supporting the multi-trillion-dollar infrastructure packages as part of the “Build Back Better” reconciliation legislation the committee is considering. This legislation can be approved with only Democratic votes. The proposed tax increases are aimed largely at high net-worth individuals and companies, staying true to Biden’s in spirit, although tax policies achieving this agenda vary from Biden’s original tax plan. All text below represents written proposals by the House Ways & Means committee which will be reviewed and debated by Congress prior to reaching the President’s desk. The below is an update to reform status but reform remains in flux.
Tax Hikes for High-Income Individuals, Gifts, Estates, and Retirement Plans
- Individual top income tax rate increase. The top personal income tax rate would be raised from 37% to 39.6% for married persons and individuals earning $450,000 and $400,000, respectively.
- High income surcharge. A 3% surtax will apply to wealthy individuals on adjusted gross income exceeding $5 million. This provision has not been previously part of Biden’s plan.
- Capital gain rate increase. Based on the current proposal, effective as of September 13, 2021, the capital gains rate would increase from 20% to 25% for certain high-income individuals. These proposed rates fall far below the ones proposed by Biden who wanted these gains to be subject to ordinary rates (e.g., proposed top rate of 39.6%).
- Net investment income tax. The 3.8% tax net investment income tax would be extended and applied to joint and single taxpayers earnings $500k and $400k, respectively. Note, this could result in certain capital gains being tax at an effective 28.8%.
- Lifetime exemption. The current estate and gift tax exemption would expire at 12/31/2021 rather than 12/31/2025. The united credit would revert to its 2010 levels of $5 million per individual (adjusted for inflation), down from the current exemption of approximately $12 million and $23.5 million for single and joint filers, respectively.
- Grantor trust. Proposed rules would result in assets held in a grantor trust to be includible in a decedent’s taxable estate. Sales between grantor trusts and their deemed owner to be treated as sales between the owner and a third party (for future trusts and future transfers). The proposal take aim at grantor trusts and is trying to mitigate their use as a tax planning vehicle.
- Valuation Discounts. Transfers of nonbusiness assets should not be afforded a valuation discount for transfer tax purposes with the goal of mitigating planning around transfers of family-owned entities having nonbusiness assets.
- Restriction on IRA Contributions. Certain taxpayers – prohibited if an individual’s IRA and defined contribution retirement accounts exceed $10 million as of the end of the prior taxable year.
- Roth rollovers and treatment of “back-door” Roth IRAs. The bill removes the ability to convert a traditional IRA into a Roth IRAs (known as “back-door” Roth IRAs). Roth conversions for IRAs and employer-sponsored plans for single and joint taxpayers earning over $400,000 and $450,000, respectively.
- Increase in minimum required distributions for retirement accounts with a high balance. The provision creates a required distribution equal to 50% of the amount by which the individual’s prior year aggregate traditional IRA, Roth IRA, and defined contribution account balance exceed $10 million. Accounts exceeding $20 million are subject to additional rules.
- Income tax rates. The proposal replaces the existing flat 21% tax rate with the following graduated tax structure:
- 18% on first $400,000;
- 21% on income from $400,000 to $5 million; and
- 26.5% top rate on all income thereafter.
The graduated corporate income tax rate is phased out at corporations making more than $10 million. In addition, professional service corps are not eligible for graduated rates. The dividend-received-deduction rules will be modified to hold constant the tax on domestic corporate-to-corporate dividends.
Combined with state income taxes, the new top rate could result in a combined income tax rate of over approximately 31%, among the highest in OECD countries. The top rate is below Biden’s proposed 28%, but higher than the 25% raided by moderate Democrats. This would be effective for tax years beginning after 12/31/2021.
- Interest expense limitation of international financial groups. Domestic corporations that are a part of international financial reporting group are subject to interest deduction limitations. The deduction is limited to domestic corporation’s earnings (specifically, EBITDA) in proportion to the larger international reporting groups earnings. This provision to corporations with large interest deductions. Specifically, it is only applicable to domestic corporations with excess interest expense over the includible amount that exceeds $12 million.
Partnership, S-Corp, and Flow-Through Impact
- Carried interest. The tax break allowing fund managers a preferential long-term capital tax rate on their share of fund’s profits would become more difficult. Legislation proposes increasing the holding period from 3 years to 5 years to obtain preferential long-term tax-exempt rates rather than ordinary income. In addition, the bill extends the application of carried interest rules to all assets eligible for long-term capital gain rates and not just specified assets listed in Section IRC 1061(c)(3).
- Deduction of Qualified Business Income (QBI) Limitation. The provision limits the Section 199A deduction for pass-through business income. The maximum allowable deduction is set at $500,000 and $400,000 for joint and single filers, respectively and be effective for tax years beginning after 12/31/2021.
- Interest expense limitation. Current rules are modified to apply the limitation on deductibility of business interest under IRC Section 163(j) to apply to partnerships and S corporations. Under IRC Section 163(j), interest deductions are limited to the limited to the sum of 30% of adjusted taxable income. In addition, changes are made so that limitation provisions apply to partnerships as aggregates, rather than to continue with the current entity treatment.
- Temporary tax-free conversions of S Corporations to Partnerships. S corporations existing on May 13, 1996 may convert or reorganize as a partnership on a tax-free basis for a two year period starting after 12/31/2021.
- Modified GILTI. GILTI is to be reported on a country-by-country basis, removing the ability to potentially combine the tax impact of low and high tax jurisdictions. (i.e., netting of GILTI tested income from one country against GILTI tested loss from another country would no longer be allowed). However, the proposal would allow tested loss to be carried forward to the succeeding tax year and offset that year’s taxable income, if any. In addition, QBAI will be reduced from 10% to 5%. Further, the provision reduces the Section 250 deduction for both FDII and GILTI to 21.875% and 37.5%, respectively. Combined with the proposed to corporate income tax rate of 26.5%, this results in effective GILTI rates of 16.56% up from the current 10.5% rate. Effective tax years after 12/31/2021 with a transaction rule for taxable years that include but do not end on 12/31/2021.
- Foreign Tax Credit Limitation. The proposal would determine a US shareholder’s foreign tax credit limitation for all baskets on a country-by-country basis, removing the ability to utilize excess credits from a high-tax jurisdiction against income from low-tax jurisdictions. The proposal also eliminates the separate limitation category for foreign branch income. Finally, the 20% haircut would be reduced to 5% allowing for use of 95% of foreign taxes paid and any excess GILTI foreign tax credits would be carried forward for 5 years with no ability to carryback to previous tax years.
- FDII. The Section 250 deduction for FDII is reduced from 37.5% to 21.875%. The deemed tangible return, unlike the GILTI QBAI, remains at 10%. Effective for tax years after 12/31/2021. This effectively accelerates the planned FDII deduction set to take place after 2025.
- Dividends Received Deduction. The proposal would limit the IRC Section 245A deduction to dividends received from CFCs where current law allows for the deduction for dividends received from “specified 10% owned foreign corporations.” U.S. shareholders would have the opportunity to elect to treat the foreign corporation as a CFC, which would potentially allow dividends from non-CFCs to be eligible for the deduction. The effect of the election under the proposal would also subject shareholders to GILTI and subpart F inclusions of the elected CFC.
Other General Business Provisions
- Qualified small business stock. The provision amends special tax exclusions rules on sales of certain qualified small business stock. Exclusion rates of 75% and 100% will be lowered to 50% exclusion when taxpayers have adjusted gross income exceeding $400,000. Effective to sales and exchanges made after September 13, 2021 if passed.
- Wash Sales. Commodities, Currencies, and digital assets (e.g., cryptocurrencies) are included in the wash sale rules. The wash sale rule limits a taxpayer from claiming tax losses when retaining an interest in the loss asset (e.g., sell loss stock and buy same stock within 30 days).
- R&D tax credit. Provisions relating to the required amortization of current R&D expenses will begin on 1/1/2026 rather than 1/1/2022. With the advent of ASC 606 income recognition, this may be a particularly large win for contract R&D manufacturers.
What Was Left Out
- Tax step-up in basis upon death. Not included in the package, despite being a key part of Biden’s tax plan. From discussions within the House on (9/15), it appears that this will remain excluded from the package.
- SALT Cap. Many moderate democrats had lobbied and continue to fight for the repeal of the 2017 tax reform law placing a $10,000 cap on the federal deduction for state and local tax payments. As of 9/15, this is a hotly contested issue within the Democratic party.
- Corporate Minimum Tax. The proposal does not include the 15% minimum corporate income tax based on a corporation’s financial net income which varies from the Biden administration. Biden originally proposed this tax on corporations meeting a $100 million threshold which was later increased to $2bn or more.
Timing and Process
- Both the House and Senate tax proposals are considered under fiscal year 2022 budget resolutions which provides that spending has to be offset in part by tax increases. Legislation is subject to limitations on the overall time for debate and can be passed by a simple majority. The Democrats hold a simple majority in both the House and Senate.
- While the House Ways and Means Committee released its draft legislation, the Senate Finance Committee have begun discussion regarding its own corporate, international, and individual tax measures to be included in the budget reconciliation legislation. Although the fiscal year begins October 1, the resolution does not need to be passed before then. Using prior reforms as guidance, we would expect enactment before year-end.