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Clark Schaefer Hackett | What You Should Know about the Ways and Means Tax Reconciliation Bill

Michigan Business Network
October 6, 2021 11:00 AM

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House budget reconciliation tax proposals could affect you greatly

The House of Representatives Ways and Means Committee has been tasked with covering the cost of a $3.5 trillion budget resolution. They’ve released detailed proposals of where the money will come from.

CSH’s Anthony Lewis reviews the budget reconciliation legislative recommendations from a general perspective, while Mark Gaudet and Larry Powell focus their discussion on the proposed estate tax changes.

House Ways and Means Committee Releases Tax Proposals

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.

* See separate article for discussion of the Estate and Gift Tax implications of the proposal.

Individuals

  • 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.

Retirement Plans

  • 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.

Businesses

  • 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.

International

  • 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.

Conclusion

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.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

Estate Taxes Change Included in Ways and Means Proposal


The House Ways and Means Committee recently released a draft proposal of new tax increases to help pay for the much anticipated $3.5 trillion House budget proposal. While this proposal will no doubt evolve as it moves through the political process, it gives us some idea of what the White House and Democrats are looking for. While there are many tax increases, the estate tax proposals may require the most immediate action for some.

Their proposal is to cut in half the current gift, estate, and generation-skipping tax (GST) exemption, diminish the value of the grantor trusts that are frequently used in estate planning, and dramatically restrict valuation discounts that have long been used to leverage gifts to beneficiaries.

Reduction in Gift, Estate, and GST Exemptions

The gift/estate/GST exemption of $5 million was passed into law back in 2010 with a scheduled increase for inflation annually. Former President Trump doubled the exemption for 2018 to 2025 with the signing of the 2017 Tax Cut and Jobs Act. Even though the higher exemption was scheduled to revert to the $5 million adjusted for inflation in 2026, the new proposal accelerates that to January 1, 2022. Thus, the current gift/estate/GST exemption of $11.7 million would be reduced to roughly $6 million.

Grantor Trust Changes

Grantor trusts, which are frequently used in estate planning, are effectively being eliminated. Current law allows grantors to irrevocably transfer assets out of their estate but continue to pay income tax on the income from the trust. This income tax payment is in effect a gift to the beneficiaries without it being treated as a taxable gift. The current proposal requires that any assets held in a grantor trust be included in the grantor’s estate.  Also, any transfers out of a grantor trust to anyone other than the grantor or spouse are treated as gifts, or if the trust’s grantor status is terminated during the grantor’s lifetime, the assets will be treated as a gift at that time. These provisions effectively have eliminated the common estate tax savings vehicles: Grantor Retained Annuity Trusts (GRATs), Spousal Lifetime Access Trusts (SLATs), and Qualified Personal Residence Trusts (QPRTs).

Another creative technique using grantor trusts involves the grantor selling assets to a grantor trust for a note at current interest rates, which are very low. This technique is called a Sale to an Intentionally Defective Grantor Trust (IDGT). Since the grantor and grantor trust are the same person for income tax purposes, the sale is disregarded for income tax purposes. This is an estate freeze technique that allows assets to appreciate, yet the trust only pays the grantor back the note plus interest at a much lower rate. If you happen to combine a sale of assets using discounted values (discussed below), then your gift is even further leveraged, and more wealth is transferred to beneficiaries. Their proposal makes this technique a taxable sale, which will certainly diminish the value of this structure. The effective date of this provision, as well as the valuation discount elimination provision explained below, is the date of enactment of the bill, which isn’t known at this point.

Valuation Discount Changes

As mentioned, valuation discounts are frequently used to transfer wealth to beneficiaries. Marketability discounts and minority interest discounts are commonly used to reduce the value of assets being gifted. For example, assume a family limited partnership is formed with contributions of marketable securities. Gifting non-controlling fractional interests of that partnership may reduce the value by 15-35% or more depending on the facts and type of assets gifted. Discounts make sense because you can’t immediately convert that gift to cash. As a minority owner, you can’t control the decisions of the majority owner, and most agreements won’t allow you to sell your interest to an outside party. Thus, the value of what you received is not worth the full value of the assets inside the entity. The current proposal eliminates these discounts for non-business assets transferred. Non-business assets include cash, marketable securities, and other assets not used in the active conduct of a business.

What Should Be Done Now?

Taxpayers that have assets over $11.7 million single, or $23.4 million married filing jointly, should consider using that exemption now. As mentioned above, most estate techniques involve grantor trusts and discounts, so we don’t know when this proposal will progress to a signed bill. However, the effective date of these provisions will be the date of enactment. This may be before the estate tax exemption decreases on January 1, 2022. Gifts made at or below the proposed exemption amounts will not help you avoid losing the exemption. For example, assume you were single now and made a gift of $6 million. In 2022, the exemption drops from $11.7 million to $6 million. With the $6 million gift, you’ve just used up your current exemption and can’t make additional non-taxable gifts. You’ve lost the opportunity to gift another $5.7 million. At a 40% estate tax rate, that will cost your heirs $5,700,000*40% = $2,280,000. This is doubled if you happen to be married and doesn’t even factor in future appreciation that will be subject to the estate tax.

The goal is to gift as much as you can up to the current exemption amounts noted above. You obviously need to factor in your lifestyle and what assets you need to maintain your lifestyle. For those that are concerned they may give away too much (and don’t want to ask their kids for money!), then a SLAT may be an answer for you if you are married. This vehicle allows for distributions back to your spouse in certain circumstances, which can alleviate some of your concerns.

The bottom line is this: if you want to take advantage of the larger gift/estate/GST exemption, please act now because the clock is ticking. You can reach out to us or your estate attorney to start the analysis and help you with your estate planning and goals.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage, or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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