By Kenneth H. Bridges, CPA, PFS December 2021
President Biden campaigned on a promise to increase taxes on the wealthy and corporations, and so, with the White House and Congress both under Democratic control, a significant increase in taxes has been anticipated by many. To date, nothing has happened.
Earlier this year, Biden proposed (amongst other things) to increase the top rate on ordinary income of individuals to 39.6%, tax long-term capital gain of higher income individuals as ordinary income (effectively almost doubling the rate on capital gains), end the step-up in tax basis at death, expand the 3.8% Medicare tax to include the income from flow-through entities of active participants, and increase the corporate rate from 21% to 28%. The capital gains rate increase would have been retroactive to April 28, 2021.
In September, the House Democrats released draft legislation which included many of the changes described above. Under this draft legislation, however, the increase in the rate on long-term capital gains would have been to 25%, and the effective date would have been gains realized after September 13, 2021.
In November, the House passed HR 5376, the Build Back Better Act (BBBA). As we go to press with this newsletter, the Senate is still debating this legislation. It is impossible to say if or when this legislation will be enacted and what changes may be made to it, but here is a high-level summary of some of what is in, and, equally important, what is NOT in the proposed legislation.
Increase in individual ordinary rate – The BBBA does NOT include (at least not directly) an increase in the individual ordinary rate. It would, however, indirectly increase the ordinary rate on very high-income individuals and trusts via the surtaxes described below and on owners of flow-through entity businesses via an expansion of the 3.8% Medicare tax on net investment income.
Increase in capital gains rate – Similarly the BBBA does NOT directly include an increase in the individual rate on long-term capital gain and qualified dividends, but would indirectly increase the rate on such for some taxpayers via the new surtaxes and expansion of the 3.8% Medicare tax on net investment income.
Surcharge on high income – Under BBBA, effective for tax years beginning after 2021, a 5% surcharge would be assessed on individual income over $10 million ($5 million for married filing separately and $200,000 for trusts), and an additional 3% surcharge would apply to income over $25 million ($12.5 million for married filing separately and $500,000 for trusts); for a total 8% surcharge.
Expansion of the 3.8% Medicare tax – The Affordable Care Act (enacted in 2010) included a 3.8% Medicare tax on “net investment income” of higher income taxpayers. The same 3.8% applies to earned income via either the FICA (for W-2 employees) or self-employment tax. K-1 income from flow-through entities in which the taxpayer materially participates and gains from the sale of such businesses have, to-date, been exempt from the 3.8% tax. The BBBA would remove this exemption for tax years beginning after 2021 for singles with income over $400,000, married filing joint with income over $500,000, and married filing separate with income over $250,000. For the owner of a flow-through entity business, this change combined with the proposed surcharges could add 11.8 percentage points to the tax on high income (for a total Federal rate on ordinary income of up to 48.8% and a total Federal rate on long-term capital gain of up to 31.8%).
Increase in the SALT cap – The Tax Cuts and Jobs Act enacted in late 2017 placed a $10,000 per year limit on individuals’ deduction for state and local taxes on Schedule A as itemized deductions. BBBA would increase this limit (retroactive to 2021) to $80,000.
QSBS exclusion limited to 50% – As we have discussed in prior issues of this newsletter, IRC 1202 provides an almost too good to be true exclusion of up to the greater of $10 million or 10x the amount invested for gain from the sale of qualifying C-corp stock held at least 5 years. For sales of qualified small business stock (QSBS) after September 13, 2021, BBBA would reduce the exclusion to a maximum of 50% of the gain.
Limitation on the 20% QBI deduction – The September version of BBBA included a provision limiting the 20% qualified business income deduction for K-1 income to a maximum of $500,000 for married couples filing jointly, $400,000 for singles and $250,000 for married filing separately. The current version of BBBA does NOT include this limitation.
Corporate tax increases – BBBA does NOT include a general increase in the 21% corporate tax rate, but does include a very controversial 15% minimum tax on book profit reported by corporations with over $1 billion of net income, a 1% excise tax on stock repurchases, and some changes in the international tax area.
Grantor trusts – Earlier proposals would have essentially eliminated the ability to do tax planning utilizing the grantor trust rules, but this is NOT included in the current version of BBBA.
Basis step-up at death – Under current law, most assets you own at death receive an income tax basis step-up to their fair market value on the date of death (allowing heirs to sell the assets free of any income tax). Earlier proposals would have limited this rule or required that tax be paid on unrealized gains at the time of death. BBBA does NOT include any such provision.
Reduction in estate tax exemption – For 2021, the exemption from estate and gift tax is $11.7 million (per spouse), and this amount is increased for inflation each year until 2026, at which time it reverts back to $5 million (as indexed for inflation since 2010). Earlier proposals would have accelerated this reversion to the $5 million level, but BBBA does NOT include such.
Statutory disallowance of syndicated conservation easement deductions – The September version of BBBA would have statutorily disallowed the conservation easement deduction for most contributions made after 12/23/16 where the deduction flowed through from a pass-through entity and the amount of such was 2.5 times or greater the amount paid for the ownership stake. This provision did NOT make it into the most recent version of BBBA.
Delay in the R&D capitalization rule – The Tax Cuts and Jobs Act legislation enacted in late 2017 included a provision whereby R&D expenses incurred in tax years after 2021 will have to be capitalized and amortized over 5 years (15 years for R&D conducted outside the US). BBBA would delay this rule until 2026.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP, an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.