The House Ways and Means Committee released 881 pages of proposed legislation on September 13th to give a nation full of underworked tax professionals something new to do in their ample spare time. Even some who work on the first floor of buildings thought about jumping out the window, but it could have been worse: there are very few complex changes. The new law would create many changes to income, estate, and gift taxes, and anyone who is about to send in a Form 2553 to file for S-election status should think twice and discuss this with the client before the deadline, as discussed below. The authors covered changes to the Estate and Gift Tax system in Estate Planning Newsletter #2906 (September 20, 2021). Now, we are back, contrary to popular demand, to cover proposed income tax changes.
While we wait to see what alterations will have to be made to the bill before it would have sufficient support from 50 senators and Vice President Harris, if this is possible, we are providing this summary of some of the most significant proposed income tax changes, proposed effective dates, and our thoughts on what actions to take and not to take. As the Senate becomes involved, all of the following proposals are subject to change, although we do not expect to see anything more detrimental to taxpayers than the current proposals.
I got my PhD in PPP
I got my MBA in EIDL – Hooray!
I survived the odyssey of ERC
And HHS has nothing on me
Now during tax season
The Ways and Means Committee Bill of 881 pages is the reason
For taxpayers to learn about the potential income tax rate increase
Knowing how to navigate the changes can bring you some peace
So if you’re serious about planning to plan
Continue reading to see what you might owe Uncle Sam
Potential Income Tax Rate Increases and Rate Bracket Adjustments
Among the most heavily discussed proposals is the increase in income tax rates, raising tax rates on ordinary income to 39.6% for individuals. This new rate would apply to married individuals who file jointly with taxable income over $450,000, to heads of households with taxable income over $425,000, to unmarried individuals with taxable income over $400,000, to married individuals filing separate returns with taxable income over $225,000, and to trusts and estates with taxable income over $12,500, as adjusted for inflation in future tax years.
Beyond the increase in tax rate, the rate brackets will also be modified with individuals on the upper end of the 32% and 35% rate brackets at risk of a potential tax rate increase as a result.
A year-by-year comparison of the rate brackets is as follows:
One strategy is to earn as much as you can while you can at our current historically low tax rates and our thankfully vibrant economy, as the rate hikes will only apply to taxable years following December 31, 2021, and your spouse is probably tired of seeing you anyway. Individuals should also consider that they will have to pay much more in income taxes due to the limitations on the 20% Section 199A Qualified Business deduction, a 3% surcharge on ultra-high earners, and the 3.8% Net Investment Income Tax that will now apply to active business income for high earners, as described below. There is a lot of math to run through before we can give a client a straight answer as to what their real effective income tax rate will be. The answer is, really high, but it could be worse. The federal income tax rates were at 70% in the 1970’s, and have previously been as high as 90%.
Viewed together, these various changes will have a severe impact on high earners and their motivation to continue earning more. An ultra-high earner subject to the surcharge could end up with a tax rate of 46.4%. If we also add in a 13% state income tax for a California resident, the tax rate shoots to approximately 60%. But remember the Beatles lyric “here’s one for you 19 for me”.[i] It could be worse.
The following chart should be helpful with respect to the proposed tax law changes that are further described below.
Proposed 25% Capital Gain Rate and Back to The Future
The maximum rate at which capital gains are taxed would increase from 20% to 25% if the new bill were to pass. This new rate would retroactively apply to sales that occur or have occurred on or after September 13, 2021, and will also apply to Qualified Dividends. The current rate of 20% will still be used for any gains and losses incurred prior to September 13, 2021, in addition to any gains that arise from transactions entered into under binding written contracts prior to September 13, 2021. Therefore, gains from sales that meet these requirements will still be taxed at the 20% rate even if received after September 13, 2021.
Expanding the Definition of “Net Investment Income” for the 3.8% Net Investment Income Tax
As previously noted, the 3.8% Net Investment Income Tax under Internal Revenue Code Section 1411 would be broadened to include any income derived in the ordinary course of business for single filers with more than $400,000 in taxable income ($500,000 for joint filers) effective January 1, 2022. Under current law, the 3.8% tax generally only applies to passive investment income (interest, dividends, gain on the sale of stock, etc.).
As mentioned above, advisors may consider delaying the filing of Form 2553 S-Elections for newly formed entities until discussions can be had with clients on the impact of the expansion of the 3.8% Net Investment Income Tax, which would apply on all S-Corp income for high earners if the bill is passed. Clients may be better served in entities taxed as partnerships or C-Corporations if S-Corporations can no longer provide the added benefit of sheltering income from the 3.8% Net Investment Income Tax. Please remember, however, that the late filing of a Form 2553 is only permitted if it is inadvertent, so clients need to be communicated with well before the deadline unless the entity can safely be taxed as a partnership or disregarded until a decision is made about whether to make an S election.
The Net Investment Income Tax will also apply to trust and estate income beginning at $13,050 of net taxable income in 2021, and the threshold will increase slightly each year. Therefore, most trusts and estates that have ownership of profitable businesses or ownership interests in profitable entities that are taxed as partnerships will be subject to the 3.8% tax except to the extent that the income received is paid out to beneficiaries. If the income received is paid out to the beneficiaries, the beneficiaries will be subject to tax as if they received it. S-Corporation income received by a complex trust is taxed at the highest bracket on Schedule K-1 from the S-Corporation regardless of whether it is distributed, and will also be subject to the 3.8% Net Investment Income Tax if it has made an ESBT (“Electing Small Business Trust”) election. However, many trusts have the ability to sell S-Corporation ownership interests to beneficiaries who are in lower brackets, so this may become a common strategy implemented shortly after the death of a client in order to not incur capital gains tax on such sale. Then the trust owns a note from the beneficiary and the beneficiary owns the S corporation stock.
A New 3% Surcharge on High Income Individuals, Trusts and Estates
Beginning January 1, 2022, if the proposed rules become law, a 3% tax will apply to individual taxpayers to the extent that they have Adjusted Gross Income (“AGI”) in excess of $5,000,000 ($2,500,000 if married but filing separately), and on trust and estate income exceeding $100,000 per trust or estate.
Because this surcharge applies to AGI in excess of the applicable threshold, AGI includes ordinary and capital gains, and is not decreased by charitable deductions (or any other itemized deduction). This tax would be imposed for most taxpayers when a business, or other large asset, is sold for a large gain. Experienced planners may consider selling to a related party under the installment method to spread out the gain over multiple tax years, keeping in mind that this would need to be completed more than two years prior to the liquidation event in order to avoid acceleration of the gain upon sale to a third party under the anti-Rushing rule, which has nothing to do with tax fraternities. Planners might also consider transferring interests that could be sold to a charitable remainder trust which can be used to spread income out over a number of years in order to avoid AGI in excess of the threshold. Running the numbers on these structures can reveal a significant tax savings if rates become lower in the future, in addition to the advantages of tax deferral and helping charities.
The Above $100,000 Trust and Estate Income Problem.
Trusts face a bigger issue under the proposed rules because the tax would apply to all trust income exceeding $100,000, making distributions of Distributable Net Income (DNI) to reduce a trust’s remaining taxable income an even more critical tool for planners. Stated in overly simplified terms, when a trust makes a distribution of income to a beneficiary, the beneficiary will pay the tax on such income, and the trust will receive a deduction to reduce its taxable income. Fortunately, the 3% surcharge will only apply to the extent that income in excess of $100,000 remains in the trust after taking into account distributions made to the beneficiaries. Drafters of trust documents should be familiar with the applicable Principal and Income Act of the situs of the trust to confirm whether capital gains are treated as principal (and thus not distributable) or income. The majority of states allow trust documents to specify that a fiduciary will have the power to treat capital gains as income that can be distributed to beneficiaries and escape the additional 3% tax.
Profitable C Corporations Should Prepare for More Taxes in 2022
The bill would also change the 21% flat corporate income tax on ‘C-Corporations” to a progressive tax, providing for 18% tax on the company’s net income of up to $400,000, a 21% tax on net income up to $5,000,000, and a 26% tax on net income in excess of $5,000,000. These rates are still significantly lower than what the corporate tax rates were before the 2017 tax cuts. A great many S-Corporations will likely be converted to C-Corporations if the bill passes and these rates go into effect, especially when viewed in light of the 3.8% Medicare tax that would be imposed on S-Corporations and flow through income for high bracket individuals.
A Haircut for High Earner 199A Qualified Organization Owners
Wealthy taxpayers claiming the 20% 199A deduction for qualified business income deductions will be disappointed to learn of the proposed maximum deduction of $500,000 for joint returns, $400,000 for individual returns, $250,000 for a married individual filing a separate return, and $10,000 for a trust or estate. Beyond this, non-corporate taxpayers still have to deal with the permanent removal of excess business losses.
All of the aforementioned business tax changes, excluding the capital gains rate, will be effective after December 31, 2021 if passed.
The IRS vs. Over $10,000,000 IRA/Pension Holders
In an effort to prevent the stockpiling of assets in massive IRA accounts, those who hold Roth and traditional IRA and retirement plan accounts with a combined balance that exceeds $10 million as of the end of a taxable year are not permitted to make further contributions if the account holder has taxable income over $400,000 or if the account is jointly held by a married couple with taxable income exceeding $450,000.
These large account holders will be prescribed to make a minimum distribution equal to “50% of the amount by which the individual’s prior year aggregate tradition IRA, Roth IRA, and defined contribution account balance exceeds the $10 million limit.” Even more severe tax treatment will apply to those who have over $20 million in combined accounts.
Further, a loophole that allowed indirect funding of Roth IRAs by the “backdoor Roth” technique could be removed for high earners.
A $10,000,000 IRA owner may be better off taking money out of the IRA this year at the lower tax brackets. Taxpayers looking for a reason to get divorced can move the $10,000,000 out of the IRA to their spouse’s IRA under a Qualified Domestic Relations Order (QDRO). Clients looking for a reason to separate from their spouse may find this to be a viable option.
The good news is that Natalie Choate has written about these proposed changes in the September 2021 addition of Choate’s Notes, which can be found at https://ataxplan.com/choates-notes. Please don’t tell Natalie Choate we mentioned her because we did not have time to get Natalie’s permission.
What About Charity?
Charitable gifting does not appear to be impacted, except for Grantor Charitable Lead Annuity Trusts. With higher income tax brackets potentially being introduced, charities may receive more in donations, which would benefit charitable causes and those who work for charities. If you will be a high earner next year, now may be the time to set up and fund that family foundation you have been considering.
The use of Charitable Remainder Trusts will become a more attractive option to spread large gains over multiple tax years in order to avoid crossing applicable income thresholds. With that in mind, some of the new provisions are applied based on Adjusted Gross Income (“AGI”) thresholds. This means that large charitable donations will not prevent taxpayers from being subject to some of the new taxes on high earners since AGI is determined before deductions for charitable contributions or any other itemized deduction.
Let’s not forget that this may be the last year that taxpayers can deduct up to 100% of AGI. Individuals who are over age 59 ½ may want to take large IRA contributions and donate the amounts withdrawn to charity as opposed to waiting until death, or only being able to donate $100,000 a year from an IRA after waiting to get into their 70’s.
Other proposed changes in the bill that are noteworthy include the following:
- The 100% gain exclusion on the sale of Section 1202 Qualified Small Business Stock will be limited to 50% of the gain for taxpayers with AGI exceeding $400,000 unless a binding contract was entered into prior to September 13th, 2021.
- Crypto currencies (Bitcoin, Ethereum, DOGEcoin, etc.) will be subject to the constructive and wash sale rules as of January 1, 2022, so if your crypto currency went “to the moon” and you want to lock in an offsetting position without triggering gain, we advise that you do so before the end of the year. If you were less fortunate and have a loss position in crypto currency, you have until the end of the year to sell your coins to harvest the loss and immediately buy back in without being subject to the wash sale rules. You would be in the same position economically, but with the added benefit of being able to recognize the loss and offset other passive income. This type of planning is prevented for most, if not for all, other marketable securities, but somehow crypto currencies have managed to stay under the radar, until now.
- IRAs can no longer invest in entities in which the IRA owner has a 10% or greater ownership interest (this is presently 50%), or if the IRA owner is an officer. This will also be considered an IRA requirement rather than a prohibited transaction, which means that if the IRA invests even a small part of its holdings in such a business the entire IRA will be disqualified resulting in loss of creditor protection status and having taxes apply as if the IRA was liquidated. There is a proposed two year transition period of IRA’s currently invested in these types of investments.
- The IRS will receive approximately $80 Billion to enforce the tax law and presumably audit many more taxpayers and bring in much more tax revenues. This will make tax professionals busier, and taxpayers more conservative. We are not sure where the IRS will find qualified people to add to their workforce given present market demands, so it may take many years before this has much of an impact out here in the real world.
- The employer tax credit for wages paid to employees during family and medical leave will expire in 2023 (2025 under present law).
- S-Corporations, that elected S-Corp status prior to May 13, 1996, will be permitted to convert tax free to a partnership any time in the two years following passage of the act. Under present law, this would result in the deemed taxable sale of all of the assets of the S-Corporation at the time of conversion, so this will be a very good opportunity for many taxpayers.
- While S-Corporations can generally convert tax-free into a C-Corporation, C-Corporations are not as flexible in regard to the distribution and allocation of income as an entity that is taxed as a partnership.
- For S-Corporation owners who wish to have greater flexibility and do not expect the ability to have significant income excluded from the Net Investment Income Tax to come back soon, this will be attractive, and it will be fun to see what Steve Gorin advises if this passes.
- There are many changes to international taxation that are better left to the international tax experts to explain, and makes us glad that we don’t have to understand the significant complexity of international tax law, which makes understanding partnership tax law actually seem possible.
- Those who deal with tax-related stress by smoking tobacco products will be sad to hear of the proposed doubling of the excise taxes on cigarettes, small cigars, and roll-your-own tobacco, in addition to several other new imposed nicotine taxes not covered by this newsletter. Many may switch to medical marijuana.
Planning to Plan
Once we have all of the aforementioned in mind, we can begin to plan, while also recognizing that what actually occurs is likely to change. Here are some examples of planning moves that may be considered at this time:
- If you have an estate plan in progress get the estate tax planning part completed as soon as possible to grandfather what we expect to be grandfathered.
- Charitable individuals who are over age 59-1/2 with large IRAs may wish to consider withdrawing monies from their IRAs and giving those monies to charity, as IRA distribution rules are changed for the worse. In addition, the ability to receive a dollar-for-dollar charitable deduction is permitted this year, but may not be allowed in the future. Until 2020, only taxpayers over age 70-1/2 can transfer IRA monies to charity on a tax-free basis, and were limited to $100,000 per year.
- Accelerating income into 2021 – Quite likely, 2021 tax rates will be much lower than 2022, and this will hopefully apply to the entire tax year.
That being the case, cash method taxpayers may accelerate income by transferring accounts receivable in late December, so that they become taxable, and may wish to defer the payment of expenses until 2022.
It is important to remember that there are advisors and others who stand to gain economically by making recommendations and implementing changes that may backfire on their clients, so caution is advised. For many individuals and families, the best thing to do is to get all of the information and documentation organized and to see a reputable tax advisor in order to be farther up in line to get properly positioned once changes are (if they are) ratified. Please don’t forget to enjoy the experience of having the opportunity to help so many in so many ways.
Without a doubt, the coming months will see plenty of people concerned about protecting their income and assets from taxation. This will drive taxpayers across the country to reacquaint themselves with their estate planners and CPAs, and motivate people to schedule their annual financial check-up. We may have to change how we do things to maximize what we can do for others while also getting some sleep here and there.