President Biden’s ambitious American Families Plan, which was introduced several weeks ago, (see related post) has become a constant topic of discussion in all news forums. With the goal of providing some clarity on the corresponding tax proposal intended to offset some of the spending in this plan, GYF is offering the following commentary to allow our clients, contacts and friends a better understanding of this piece of the President’s Build Back Better agenda. The information below is excerpted from a Fact Sheet published by the White House in an effort to shed some light on the key provisions of the American Families Plan.
Increase in top marginal federal tax rate for individuals (from 37% to 39.6%)
The proposal would restore the top marginal individual income tax rate to 39.6%. The President’s plan restores the top tax bracket to what it was before the 2017 law, returning the rate to 39.6%, applying only to those within the top 1%.
While the rate increase noted would apply to higher income individuals, it is unclear if the coming legislation will exempt pass-through business income that is not followed by cash distributions. If such is not the case, small businesses structured as S corporations, partnerships and limited liability companies will most certainly need to distribute greater amounts of cash flow to meet owner tax liabilities on that income.
Increase in current capital gain rates for households making over $1 million
The President’s plan proposes to eliminate the current preferential capital gains rate for certain “higher income” individuals. The fact sheet contains language that states “households making over $1 million – the top 0.3% of all households – will pay the same 39.6% rate on all their income, equalizing the rate paid on investment returns and wages.” However, at this time, it remains unknown whether the $1 million threshold applies to adjusted gross income, taxable income, or some other measure.
Details are limited at the current time, but an exclusion for privately held business owners’ sale of their businesses would be helpful. For example, an entrepreneur who started his or her own business on a shoestring budget, employed 25 people for two decades and, in preparing for retirement, sells the business for $10,000,000, should not be penalized by such a significant change in the capital gains rate. The proposal, as advanced in the Fact Sheet, could cost this individual almost $2 million.
It does appear that politicians on both sides of the aisle often fail to distinguish between a taxpayer earning $3 million in cash compensation and a small business owner with a $250,000 salary and $2,750,000 in “non-cash pass-through” income. Moreover, given the fact that income tax at the highest marginal rates has always been paid on the passed-through income, taxing the gain upon sale of that business at ordinary income tax rates seems extremely onerous.
Major reduction in step-up of decedent’s tax basis on assets inherited at death
A very significant proposed change is the apparent taxation of excess appreciation in assets held when a person dies. The Fact Sheet notes, “Today, our tax laws allow these accumulated gains to be passed down across generations untaxed, exacerbating inequality. The President’s plan will close this loophole, ending the practice of “stepping-up” the basis for gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions) and making sure the gains are taxed if the property is not donated to charity.”
This provision is not yet fully explained, however, it is possible that those gains in excess of $1,000,000 will be taxed under a mark-to-market system upon death. If the gain were to be immediately subjected to tax, it seems the basis should be stepped up under current income tax principles. The Fact Sheet does not provide a sufficient level of detail to be certain of the proposed tax treatment. Final language when the draft legislation is released could clarify if the provision is intended to simply restore EGTRRA’s limited basis step-up at death (without eliminating the estate tax in exchange for the loss of basis step-up.)
Clarity and further explanation of the President’s intent will be very important in understanding the impact of this provision, including how and whether this will apply to assets passed to a surviving spouse. The Fact Sheet does note, “The reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.”
For untaxed excess gains over $1 million, to which the new provision would apply, the effect on wealthy taxpayers’ heirs will be significant. There already seems to be some question as to whether the Treasury can “tax” the value of the inherited asset first in an estate tax and then, again, via the income tax by not permitting the step-up for heirs. While some commentary suggests a lack of constitutionality, the two taxes are different, and only time will tell if the provisions can be enacted as currently proposed.
It is certain, however, that estate tax planning to protect family assets and wealth (the need for which had all but disappeared for most taxpayers due primarily to the current expanded lifetime exclusion) will take on added significance for many taxpayers if the proposal is enacted as currently suggested in the Fact Sheet.
Change in capital gains treatment for carried interests
The issue of “carried interests” has been heavily discussed for many years by the media and in Congress, and was a front-and-center issue during the process of negotiating and passing the Tax Cuts and Jobs Act (TCJA) in late 2017. While it had been originally proposed as part of the TCJA to force income from carried interests to be taxed as ordinary income, the provision was ultimately diluted in the final version of TCJA. President Biden apparently wants to try once more to change the tax treatment of carried interest income as part of this proposal.
The Fact Sheet provides, “The President is also calling on Congress to close the carried interest loophole so that hedge fund partners will pay ordinary income rates on their income just like every other worker. While equalizing tax rates on wages and capital gains will address this disparity, permanently eliminating carried interest is an important structural change that is necessary to ensure that we have a tax code that treats all workers fairly.”
As noted above, equalization of the capital gains rates and the ordinary income tax rates essentially eliminates the issue at the current time. The inclusion of this provision seems to be an attempt to ensure that the carried interest never resurfaces should rates change in the future.
Elimination of like-kind exchange deferral for real estate gains in excess of $500,000
The TCJA eliminated like-kind exchange treatment for any assets aside from real estate held for income producing or business purposes. The new proposal would, again, reduce the number of transactions eligible for like-kind exchange deferral treatment, providing a cap on the dollar level of gains and restricting the preferential tax strategy to gains of $500,000 or less.
Deferral opportunities for gains on property transactions continue to shrink, and this provision is simply one new example of this trend. It appears to be the ultimate intent of Congress to accelerate the immediate collection of tax liabilities wherever possible.
It is difficult to discern exactly where changes such as this will lead the economy, in general, and the real estate industry, in particular. In a like-kind exchange, the investor/taxpayer continues his or her investment in similar property without the burden of paying tax at the date of the exchange so long as the value is “reinvested” in similar assets. Acceleration of the tax obligation to the date of the transaction will require substantial cash flows to fund those liabilities. Lower residual cash flows are certain to restrict the ability of investors/taxpayers to reinvest in similar properties.
Expansion of the net investment income tax (NIIT) of 3.8% to apply those taxes consistently to “those making over $400,000”
The Fact Sheet provides the following, “…high-income workers and investors generally pay a 3.8 percent Medicare tax on their earnings, but the application is inconsistent across taxpayers due to holes in the law. The President’s tax reform would apply the taxes consistently to those making over $400,000, ensuring that all high-income Americans pay the same Medicare taxes.”
This provision appears to ensure that income in excess of $400,000 would be subjected to either the Medicare taxes or the net investment income tax. Currently, if a person is actively involved in an S corporation, any flow-through income the person receives from the S corporation is not subject to either of these taxes.
The President campaigned on a promise to subject non-compensatory S corporation income to social security and Medicare tax. While this provision is not as extensive as that campaign promise, it would work to add a 3.8% tax cost to the pass-through income of an S corporation.
In a sense, this treatment corresponds with historical tax treatment of S corporations by most tax practitioners. Under this treatment, amounts paid as wages have been subjected to the social security and Medicare taxes associated with all employees. The balance of the S corporation’s income is passed through to the owner(s) as an investment return without consideration of social security and Medicare tax. The net investment income tax was added to help fund the Affordable Care Act (ACA), but the definition of investment income in those rules failed to consider the investment return in an S corporation.
Additional proposed changes
- The Fact Sheet states, “…the President would also permanently extend the current limitation in place that restricts large, excess business losses, 80 percent of which benefits those making over $1 million.”
- The President’s plan also proposes to make permanent or significantly extend a number of new individual tax credits that were added on a temporary basis in the American Rescue Plan Act of 2021, including:
- Extend the expanded ACA premiums tax credits
- Extend the Child Tax Credit increases through 2025, and permanently make the credit fully refundable
- Permanently increase childcare tax credits to support families with childcare needs
- Make the Earned Income Tax Credit Expansion for childless workers permanent.
All legislation must go through a complex process of negotiation and debate prior to passage. At the current time, this plan has yet to be fully formulated, and it appears that the White House is trying to gain an understanding of how it will be received by the public prior to drafting the actual proposal.
Grossman Yanak & Ford LLP will continue to post updates to keep our readers current on the issues. In the meantime, please direct any questions or comments you may have to Bob Grossman or Don Johnston at 412-338-9300.