Article by Anthony Lewis, CPA
In August, the House of Representatives and the Senate passed an approximately $3.5 trillion budget resolution. They assigned the House Ways and Means and the Senate Finance Committees with the task of coming up with enough tax changes and increases to cover the cost.
On September 13, the House Ways and Means Committee released their proposed tax reform legislation. While the proposed tax reforms are subject to change, the proposal largely keeps intact the framework established in the 2017 Tax Cuts and Jobs Act. This proposal instead touches on a wide range of tax issues including changing tax rates and altering selected provisions of the Internal Revenue Code.
This is the first step in a multi-step process that will need to be completed before any of the proposed legislation becomes law and it is likely that significant changes will be made during the process. The tax proposals next go to the House Budget Committee to be added to the rest of the $3.5 trillion reconciliation bill. It is important to recognize that, given the steps left to be completed in the process, these tax changes may never become law in their current proposed form.
Nevertheless, tax changes are expected to be enacted this year and the proposals by the House Ways and Means Committee have laid the groundwork for possible tax reforms to come.
Most of the proposals are intended to be effective after December 31, 2021 (with the notable exception of the capital gains rate increases, described below); however, the effective date with respect to the proposal is subject to change until finalized.
Outlined below is a high-level overview of some of the key provisions affecting individuals and businesses that are contained in the Ways and Means Committee’s proposed legislation.
- The top marginal income tax rate would increase from 37% to 39.6% for married filing joint returns with taxable income over $450,000 (single taxpayers over $400,000 taxable income and married filing separate returns with over $225,000).
- The long-term capital gains rate would increase from 20% to 25%, retroactive to any sale after September 13, 2021. Gains recognized after the effective date that arise from transactions entered into pursuant a written binding contract (with no material modifications thereafter) would be treated as occurring prior to the effective date.
- A new 3% surtax on modified adjusted gross income (AGI) in excess of $5 million (or $2.5 million for married filing separately). This change will in effect increase the top federal tax rates that apply to ordinary income and capital gains.
- The 3.8% net investment income tax would be extended to cover net investment income derived in the ordinary course of a trade or business for individuals with taxable income of greater than $400,000 or $500,000 for married filing jointly, regardless of whether the taxpayer materially participates in the business.
- The deduction for qualified business income under Section 199A would be limited to $500,000 for joint filers and $400,000 for individuals.
- The proposal would increase the holding period to receive long-term capital gain treatment for carried interest from three to five years. There would be an exception for real property trades or businesses and taxpayers with adjusted gross income less than $400,000 where the current three-year holding period would remain.
- Under a temporary provision, excess business losses (EBLs) of non-corporate taxpayers higher than $500,000 for joint filers ($250,000 for all others) are disallowed and treated as net operating losses in the following year. The proposal would make this temporary provision permanent and modify how disallowed EBL is treated.
- The 75% and 100% exclusion rates for gains realized from the sale of certain qualified small business stock would not apply to taxpayers with AGI of $400,000 or more. This change would be applicable to sales and exchanges after September 13, 2021, subject to a binding contract exception.
- The bill would extend Section 1259 constructive sales rules and Section 1091 wash sale rules to digital assets, such as cryptocurrencies.
Note: The proposed legislation does not include a repeal of the $10,000 limit on the state and local tax deduction for individual taxpayers. It is currently unclear whether this provision will be added to the proposed legislation later in the process or included in other legislation.
- The proposal would prohibit taxpayers with taxable income exceeding $450,000 for joint filers ($400,000 for individuals) and with more than $10 million of aggregated retirement account assets from being able to make new retirement account contributions.
- The proposals would eliminate the so-called backdoor Roth IRA conversion strategies for both IRAs and employer-sponsored plans for taxpayers with taxable income exceeding the limits noted above.
- For taxpayers with taxable income in excess of the limits noted above whose combined traditional IRA, Roth IRA, and defined contribution retirement account balances exceed $10 million at the end of a taxable year, a minimum distribution would be required for the following year equal to 50% of the amount by which the prior year combined account balances exceed $10 million.
- An IRA would be prohibited from holding any security if the issuer of the security requires the IRA owner to have a certain minimum level of assets or income, has completed a minimum level of education, or obtained a specific license or credential (e.g., investments offered to accredited investors). IRAs holding such investments would lose their IRA status. There would be a two-year transition period for IRAs already holding these investments.
- The proposal would lower the current 50% ownership threshold to 10% for the investment of IRA assets in non-publicly traded entities in which the IRA owner has a substantial interest.
- The corporate income tax rate structure would change to 18% on the first $400,000 of income, 21% on income up to $5 million, and 26.5% on income above $5 million.
- The proposal would create a new interest deduction limitation, Code Section 163(n), which would apply to a domestic corporation that is a part of an international financial reporting group. This limitation would apply to domestic corporations with a rolling three-year average excess interest expense over $12 million.
- This proposal would also prohibit a company from engaging in a tax-free leveraged spin-off transaction of its subsidiary without incurring a corporate level tax.
- Under this proposal, in the case of a taxable liquidation of a corporate subsidiary, no loss may be recognized on the stock of the liquidating corporation until the corporation receiving property in the liquidation disposes of substantially all of the property received to an unrelated party.
- The proposals would permit any corporation that was an S corporation on May 13, 1996, to convert or reorganize as a partnership on a tax-free basis, during the two-year period beginning December 31, 2021.
- The proposal would increase the effective tax rate on global intangible low-taxed income (GILTI) from the current 10.5% to a 16.5625% rate.
- The proposal would lower the Section 250 deduction percentage for GILTI from 50% to 37.5%. When combined with the proposed corporate tax rate of 26.5%, the resulting effective GILTI would be 18.5625%.
- The foreign tax credit limitations would be determined on a country-by-country basis, for all baskets. This would prevent excess foreign tax credits from high-tax jurisdictions from being credited against income from low-tax jurisdictions.
- The proposal would increase the base erosion and anti-abuse tax (BEAT) rate from 10% to 12.5% for tax years beginning after December 31, 2023, and before January 1, 2026; for tax years beginning after December 31, 2025, the rate would increase from 12.5% to 15%.
- The proposal would limit the Section 245A deduction to dividends received from controlled foreign corporations (CFCs), whereas current law allows the deduction for dividends received from “specified 10%-owned foreign corporations.”
- The proposal would reinstate Section 958(b)(4) to prohibit downward attribution from a foreign corporation, retroactive to December 31, 2017, and would add new Section 951B to more narrowly allow downward attribution only to foreign-controlled U.S. corporations.
None of the above proposed tax changes have become law. These tax proposals are subject to amendment and passage by the House and the Senate and signature by the President. However, this is a first major step to begin understanding which tax proposals Congress will use to attempt to balance revenue and spending priorities as well as the specifics of how the tax proposals will apply.
Clark Schaefer Hackett will continue to monitor the progress of the proposed tax reform legislation and keep you informed of important developments.