By: Derek Gray, CPA, Director
On the morning of September 13, 2021, the House Ways and Means Committee released details of proposed tax increases totaling $2.9 trillion. The revenue raised from these increases, along with an additional $600 billion coming from dynamic growth, is intended to pay for the Democrats’ proposed $3.5 trillion budget bill.
The more than 800 pages of text contains several proposals that fall short of what the Biden administration has previously proposed, either on the campaign trail or in the administration’s proposed fiscal year 2021 budget released earlier this year.
To account for revenue lost from these scaled-back proposals, there are a host of new tax increases which largely target high-income individuals and large multi-national businesses.
While Republicans and moderate Democrats may celebrate some of the compromises, such as capital gains rates and corporate tax rates, there is little room for further negotiation if these recommendations are intended to cover the entire proposed $3.5 trillion cost of the proposed budget package. As such, the newer proposals, such as expanding the Net Investment Income Tax (NIIT), will become must-wins for the Democrats if they hope to keep the $3.5 trillion price tag. Expect Republicans and even some Democrats to push back on these newer proposals, and there will certainly be much debate over the next few weeks on the price of legislation.
Summary of Ways and Means Committee Proposed Tax Changes
Increase top marginal individual income tax rate from 37% to 39.6%:
This increase would set the highest individual income tax rates at a pre-2017 level and is expected to raise $170 billion over a 10-year period. We have expected this to be a cornerstone of any legislative package this fall, so its inclusion is no surprise. Expect this to be included in any legislation that eventually makes its way to President Biden’s desk.
Increase top capital gains rate from 20% to 25%:
This increase seems about as good as anyone opposing capital gains rate increases could hope for. Recall that in the Biden administration’s budget resolution, the proposal was to increase capital gains rate to 39.6% for anyone making more than $1 million and that change would have been retroactive to April 2021.
While the highest capital gains rate has dropped significantly, the income level at which the 25% rate would kick in is now linked to the 39.6% income tax bracket. In other words, married couples making more than $450,000 would be subject to capital gains rates at 25%. The tax rate increase would be retroactive to the release of this proposal on 9/13/21, rather than April 2021 (as was proposed earlier this year by President Biden).
Individuals making more than $1 million are likely pretty happy with this proposal, as it is a huge tax savings over other options that have been discussed. Those making more than $400,000, but less than $1 million, may not be terribly happy, but a 5% rate increase isn’t likely to ruffle too many feathers. If it holds, this seems like a fair compromise. However, if other revenue raisers are removed from a future bill, don’t be surprised if the capital gains rates are targeted for additional increases, perhaps in a 28% rate with the lower income floor of $400,000 for single taxpayers and $450,000 for married couples.
Expansion of the Net Investment Income Tax:
Under the current law, the Net Investment Income Tax (NIIT) adds an extra 3.8% surtax on the investment income (interest, dividends, capital gains, passive pass-through income, etc.) for high-earning individuals. The expansion proposed by House Democrats would now include all income derived in the ordinary course of a trade or business (non-passive pass-through income and income from a sole proprietorships), with the goal of equalizing the tax rates on all income for high earners to be inclusive of the additional 3.8% tax.
This provision was mentioned by President Biden on the campaign trail, then largely forgotten about until now, as it was not included in the FY 2021 budget proposal. Democrats have been fond of the NIIT for some time (it was introduced in its current form in the first Obama administration), so with a need for additional revenue after not raising capital gain rates and corporate tax rates, it’s not a huge surprise they’ve looked to this as a revenue offset to some spending costs. The expansion of the NIIT is expected to raise more than $250 billion over the next 10 years.
Limiting the Qualified Business Income (IRC Sec. 199A) deduction:
One of the hallmarks of the Tax Cuts and Jobs Act (TCJA) passed in 2017 was the introduction of a 20% deduction on all business income that wasn’t a “specified service.” This deduction has helped lower the tax bills of high-income earners as well as small business owners over the last four (4) years. Currently set to sunset after 2025, the Biden administration often mentioned accelerating the sunset or outright repealing the deduction. Ways and Means didn’t go that far but is looking to raise approximately $78 billion of revenue by limiting the amount of allowable qualified business income (QBI)deduction to $500,000 for married couples, $400,000 or individuals and $10,000 for estates and trusts.
Limiting the IRC Sec. 199A deduction will not be popular with the Republicans, but it’s likely to poll very well. After all, to achieve a $500,000 QBI deduction, a taxpayer would need $2.5 million of qualified income. It’s unlikely that most of the voting public is going to lose too much sleep over increasing taxes for families making more than that amount.
Extension of the limitation on excess business losses:
Under current law, any business losses (partnership, S-corporation or sole-proprietor) are limited annually to $500,000 for married couples and $250,000 for individuals. The Ways and Means Committee recommends that the current limitations, which are in effect until 2027, be made permanent.
Because this is just an extension of a law already in effect and this tax increase has largely flown under the radar since it was enacted, we don’t anticipate too much push back from Republicans or the moderate Democrats. We expect this measure will be included in the final version of the law.
Imposition of a 3% surtax on income in excess of $5 million:
Rather simple in theory and execution, this provision would assess a 3% surtax (in addition to all other taxes) on individuals making more than $2.5 million of adjusted gross income (AGI) and married couples making more than $5 million of AGI. This provision, which is expected to raise $127 billion over 10 years, would also apply to trusts with income of more than $100,000.
This measure appeals to the proponents of a wealth tax, such as Senators Bernie Sanders and Elizabeth Warren. While it stops short of some of the more aggressive proposals introduced by Sen. Sanders and Sen. Warren, it may be seen as a compromise between those wanting a wealth tax assessed on overall wealth and the moderates in the Democratic party. Expect this measure to be fiercely contested by Republicans, even if the voting public is largely supportive of the measure. By implementing this as an additional tax on income, rather than wealth, it likely skirts around some of the delicate legal issues about the constitutionality of a wealth tax
Changes to estate and gift taxation:
Prior to 2017, the lifetime exemption amount for gifts and taxable estates was set at $5.5 million per person and indexed for inflation. When TCJA was enacted, those amounts doubled, rendering the estate tax a non-issue for all but the wealthiest of wealthy Americans. Due to some complex legislative issues when enacted, however, this increase in the lifetime exemption could not be made permanent and is currently set to expire at the end of 2025. The Ways and Means Committee has proposed to accelerate the expiration to December 31, 2021.
A second provision proposes the disallowance of discounts based on lack of marketability and minority interests. For years, practitioners have been able to discount the value of a gift, for example, because a 10% interest in a closely held partnership couldn’t be readily sold on an open market, nor could a minority owner exercise any substantial control over the partnership itself. This provision would disallow those discounts for passive investments.
Perhaps the most notable thing about these proposals is what isn’t included in them. There is no repeal of the basis step up at death, as has long been discussed as a potential revenue raiser. Also not mentioned are provisions making gifts and death taxable events, as President Biden introduced in his budget proposal earlier this year.
If this is the extent to which Congress attempts to change estate and gift taxation, opponents of increases in this area may be so inclined to take this deal. Certainly, the outcome could have been far more onerous and completely overhauled estate and gift taxation as we’ve known it for the last 100 or so years. Nevertheless, don’t be surprised if this isn’t the last we hear of estate and gift changes. Despite the relatively low amount of revenue that can be raised from these measures, many Democrats are unsympathetic to the transfer of generational wealth and may look to pick up additional revenue in this space if other provisions of the proposed tax increases are cut.
Other individual tax proposals:
Also proposed by the Ways and Means Committee are changes to permanently ban “back-door” Roth IRA conversions, as well as adjusting the income levels at which a taxpayer can convert a traditional IRA to a Roth IRA and closing the loopholes related to conservation easement deductions.
Further, the proposals also seek to change the way carried interests are taxed, disallow further contributions to IRAs once they reach a certain account balance, and modify the wash sale rules for cryptocurrency.
Increase to corporate tax rates:
In a measure projected to raise approximately $540 billion over 10 years, the highest corporate tax rate would increase from a 21% rate to a 26.5% rate on corporate income in excess of $5 million. This proposal reintroduces a graduated tax scale for C-corporations and lowers corporate taxes to 18% for any corporations making less than $400,000. For corporations with income between $400,000 and $5 million the tax rate would remain 21% and for corporations with income more than $10 million, the tax rate effectively becomes 26.5% on all income.
When TCJA decreased the corporate tax rate from 35% to a flat 21%, the measure was applauded by most Republicans and opposed by many Democrats. It was long thought that a compromise may be reached with a corporate tax rate that ended up at 28%, and that was frequently mentioned by President Biden on the campaign trail. This proposal seems to be an attempt by Democrats to compromise on the issue. Like capital gains rates and estate and gift taxation, this may be an area where Republicans are quick to accept this Democratic compromise; however, it could also be an area that lawmakers come back to for additional revenue if needed. Nevertheless, this proposal seems to indicate that we don’t expect any 2021 legislation to include a corporate tax rate exceeding 28%.
International tax provisions:
The laws surrounding international tax are exceedingly complicated and have been through significant change in the last few years. The acronyms alone are hard enough to keep track of, let alone the laws and structure behind them. Be on the lookout for increases to the Global Intangible Low-Taxed Income (GILTI), increases to the Base Erosion Anti-Abuse Tax (BEAT) and modifications to the Foreign Derived Intangible Income (FDII) regime.
Many lawmakers have long despised perceived abuses in the way large, multi-national companies have been able to take advantage of the US tax system by locating certain operations overseas. The modification to the above regimes largely targets large corporations, although many smaller companies will also feel the bite of these tax increases and increased compliance costs. The expected revenue raise from the international provisions is expected to generate in the neighborhood of $900 billion over 10 years.
Make no mistake about it, the proposals by the Ways and Means Committee contain several provisions that would increase income taxes for high income individuals and businesses alike. However, in light of more aggressive measures proposed by the Biden administration on the campaign trail and since they’ve taken office, much of what has been proposed seems like a reasonable compromise relative to more aggressive tax increases that have been mentioned in the past.
Think of this as the starting point for the debate on tax reform that will take place over the next few weeks. Many of the measures discussed above are not in their final form if they become legislation at all.
If you have questions or concerns about how the Ways and Means Committee’s proposals might impact you, please reach out to Derek Gray at firstname.lastname@example.org or your local Blue and Co., LLC tax advisor.