Congress Considers Tax Changes: Ways & Means Proposal 2021
The political situation is in flux as Congress debates the upcoming federal debt limit authorization. Nevertheless, the tax proposals issued by the House Ways and Means Committee indicate some of the issues at stake. The Ways and Means Committee issued a summary report on September 13th, and we touch on some of the topics that apply to many of our clients.
As the legislation moves through Congress, some of the provisions may change.
Corporate Income Tax
The 2017 Tax Cuts and Jobs Act changed the long-standing corporate tax rate from four brackets topping out at 35% to a flat rate of 21%. The Ways and Means Committee proposal will reinstitute tax brackets, ranging from 18% on the first $400,000 of income, 21% of income up to $5 million and 26.5% for income $5 million and over. The lower rates will phase out for corporations earning more than $10 million. Personal service corporations will be subject to a flat tax at the higher rate, just as they were prior to the 2017 act.
Converting an S Corporation to a Partnership
Under current law, a partnership may convert to a corporation tax-free, but a corporation must pay tax on its appreciated property if it converts to a partnership. The Ways and Means proposal will allow S corporations to convert tax-free to partnerships. This is a temporary provision that will apply only during 2022 and 2023.
Foreign tax credits will be computed on a country-by-county basis rather than aggregating all the various countries. The carryforward of excess foreign tax credits will be reduced from up to 10 years to up to five years.
The carried-interest rule was previously enacted to apply to individuals who provide services to partnerships in exchange for interests that would produce capital gains. Congress saw the capital gain treatment as allowing disparate taxation when compared to the ordinary income treatment that applies to other service providers. The carried-interest rule provides for a three-year holding period for a carried interest to be treated as long-term capital gain. The current proposal will increase the holding period to five years, but retain the three-year holding period for real property trades and businesses and for taxpayers with an adjusted gross income less than $400,000.
If a taxpayer sells stock at a loss and repurchases it within 60 days, the loss is considered a wash sale and is not deductible. The Ways and Means proposal extends wash sale treatment to commodities, currencies, and digital assets (i.e., cryptocurrency).
The top marginal rate was reduced from 39.6% to 37% by the 2017 Act, and the Ways and Means proposal will reinstate a top rate of 39.6%. The thresholds are over $450,000 for married filing jointly, over $425,000 for heads of households, over $400,000 to unmarried individuals, over $225,000 for married filing separately, and over $12,500 for estates and trusts. In addition, there will be an additional 3% tax on taxpayers with adjustment gross income in excess of $5 million ($2.5 million for married filing separately).
The capital gains rate will increase from 20% to 25%. This provision will not be retroactive to the beginning of the tax year, which means it will only apply to sales that take place after the law is enacted.
The net investment income tax will be expanded to apply to investment income derived in the ordinary course of a trade or business for taxpayers with income over $500,000 (married filing jointly), $400,000 (all other individuals) and trusts and estates.
The qualified business income deduction under Code §199A (commonly called QBI) will be limited to $500,000 for a joint return, $400,000 for an unmarried taxpayer, $250,000 for married filing separately, and $10,000 for a trust or estate.
The 2017 Act limited the use of excess business losses (i.e., business losses in excess of business income) against other income. The CARES Act suspended the limitations. The Ways and Means proposal disallows excess business losses; they will be carried forward to future years.
The 2017 Act increased the estate and gift tax exemption amount from $5 million (adjusted for inflation) to $10 million (adjusted for inflation). The exemption amount for 2021 is currently $11.7 million and is scheduled to return to $5 million (adjusted for inflation) in 2026. The Ways and Means proposal will accelerate the return to $5 million (adjusted for inflation), presumably effective on the date of enactment.
Under current law, an individual (the “grantor”) can create a trust whose current income is taxed to the grantor even though the beneficiaries receive the assets; the grantor pays gift tax on the current value of the trust but any future increase in value escapes estate tax. This is called an intentionally defective grantor trust. The Ways and Means proposal eliminates the estate tax benefit of using intentionally defective grantor trusts: the assets will be included in the decedent’s taxable estate.
The popular press has recently reported on very wealthy individuals who receive the same tax benefits from their highly-funded retirement plans that apply to less well-situated taxpayers. The Ways and Means proposal will prohibit further contributions to IRA or Roth accounts that exceeds $10 million as of the end of the prior year and where the taxpayers have taxable income over $450,000 for married filing jointly, $425,000 for heads of households, and $400,000 for others (amounts indexed for inflation). Those taxpayers affected by this limit will be required to distribute 50% of the balance over $10 million.
An additional required minimum distribution applies to taxpayers whose aggregate plan balances exceed $20 million. They must distribute the lesser of the balance in all Roth accounts of the amount needed to bring the total balance down to $20 million.
An IRA contribution reduces current taxable income; the future distribution is taxed as ordinary income. A Roth IRA contribution does not reduce current taxable income, but future distributions (i.e., future earnings) are tax free. Roth contributions are phased out once income passes a threshold (i.e., single taxpayers in 2021 earning $125,000). However, taxpayers may convert a traditional IRA to a Roth IRA, paying current income tax on the amount in the IRA account in return for being able to withdraw future Roth earnings tax-free. This provision allowed higher-income taxpayers the benefit of a Roth account (sometimes called a “backdoor Roth IRA”).The Ways and Means proposal eliminates Roth conversions for married taxpayers filing jointly with taxable income of $450,000, heads of households with taxable income over $425,000, and single taxpayers with taxable income over $400,000 (all amounts adjusted for inflation).
We will monitor the situation and keep you informed as the proposal wends its way to enactment.
If you would like additional information please contact your Gettry Marcus Advisor.