The Build Back Better Act: Proposed Tax Changes

On September 13, 2021, the House Ways and Means Committee released draft legislation to be included as part of the Build Back Better Act, the $3.5 trillion budget reconciliation bill currently being negotiated by Congress. The legislation has recently been advanced by the House Budget Committee to eventually be voted on before the full House. In its current form, it does not appear to have enough support in the Senate and changes are expected. The cost of the legislation is proposed to be funded by a variety of tax proposals.

PROPOSED INDIVIDUAL CHANGES

Top Marginal Income Tax Rate Increase

The top individual marginal tax rate would revert to 39.6% from the current 37% top rate that became effective in 2018 after passage of the Tax Cuts and Jobs Act. This 39.6% rate would take effect for tax years beginning after December 31, 2021 and would apply to taxable incomes greater than:

  • $450,000 for married individuals filing jointly
  • $425,000 for head of households
  • $400,000 for single individuals
  • $225,000 for married individuals filing separately
  • $12,500 or estates and trusts

Capital Gains

The top capital gains tax would change from the current 20% rate to 25% for the highest income brackets. Currently, in 2021, the 20% rate applies to incomes greater than $501,600 for married individuals filing jointly and $445,850 for single filers. These thresholds would also be changed to align with the new proposed ordinary income tax brackets. The 25% rate also seems to extend to taxes on qualified dividends, personal holding companies, and accumulated earnings.

Transitional rules are proposed that would have the 25% rate apply to net gains realized after September 13, 2021, with net gains realized prior to this date being taxed at the current 20% rate.

Surcharge on High-Income Individuals

The proposed legislation includes a new 3% surcharge for most filers with modified adjusted gross income greater than $5 million and is expected to raise $127 billion in revenue over 10 years. The threshold is $2.5 million for married filing separate and $100,000 for trusts and estates. The proposal would be effective for taxable years beginning after December 31, 2021.

Net Investment Income Tax

The 3.8% Net Investment Income Tax (NIIT) went into effect in 2013 as part of the revenue raising items designed to offset the costs of the Affordable Care Act. The tax applies to filers with Net Investment Income and modified adjusted gross income greater than $250,000 for married filers and $200,000 for single filers. Under current law, common types of income subject to NIIT includes, but is not limited to:

  • Interest
  • Dividends
  • Capital gains
  • Rent and royalty income
  • Businesses that trade financial instruments or commodities
  • Businesses that are considered passive activities to the taxpayer

It does not apply to ordinary business income or income attributable to the sale of property earned outside of a passive activity. The proposed legislation eliminates those exceptions and broadens the types of income subject to NIIT.

Under the proposal, NIIT would apply to the greater of "specified net income" or net income for high individuals, estates, and trusts. "Specified net income" includes ordinary trade or business income and income from the sale of property outside a passive activity. Certain foreign income is also included.

Under the legislation, NIIT would apply to taxpayers with modified adjusted gross incomes above $500,000 for married individuals filing jointly, $400,000 for single filers, and $12,500 for trusts estates. The proposal would be effective for taxable years beginning after December 31, 2021.

Carried Interests

The holding period to obtain long-term capital gain treatment for gain allocated to a carried interest partner is three years. The proposal would extend the holding period from three to five years. The three-year holding period would remain in effect with respect to any income attributable to real property trades or businesses and for taxpayers (other than an estate or trust) with adjusted gross income of less than $400,000. The proposal also contains provisions to include all items that are treated as capital gain (for example, Section 1231 gain) and prevent avoidance of the holding period rules. It would be effective for taxable years beginning after December 31, 2021.

Qualified Business Income Deduction

The Qualified Business Income Deduction (QBID) is a 20% deduction for pass-through businesses introduced as part of the Tax Cuts and Jobs Act. There are currently thresholds related to wages paid or property held that must be met for high income individuals to qualify for the deduction, provided those criteria are met there are no additional limitations on the amount of QBID allowable.

The proposal would limit the maximum amount of QBID to $500,000 for married individuals filing jointly, $400,000 for single filers and $10,000 for estates and trusts. It would be effective for taxable years beginning after December 31, 2021.

Transfers Between Deemed Owner and Irrevocable Grantor Trust

Transfers between a deemed owner and his or her irrevocable grantor trust are currently nontaxable events. The proposal would disregard grantor trust status when determining whether a transfer between a deemed owner and his or her grantor trust is a sale or an exchange, possibly resulting in a taxable event. Additionally, the proposal would expand the definition of related party under Internal Revenue Code Section 267(b) to include grantor trusts and their deemed owners. The proposal would apply to trusts created on or after the date of the enactment of this provision and to any portion of a trust established before the date of enactment that is attributable to a contribution made on or after such date.

PROPOSED ESTATE AND GIFT TAX CHANGES

Estate Tax Basic Exclusion Amount

The estate tax lifetime exclusion amount is $11,700,000 for 2021. The proposal would terminate the temporary increase in the lifetime exclusion amount, returning that amount to $5,000,000, indexed for inflation. Under this proposal, the lifetime exclusion amount in 2022 is anticipated to be $6,030,000. The proposal would apply to estates of decedents dying and gifts made after December 31, 2021.

Grantor Trusts

When a deemed owner of a grantor trust dies, the assets of that grantor trust (other than a fully revocable trust) are generally not included in the deemed owner’s estate. The proposal would require that assets in a grantor trust be included in the gross estate of the deceased deemed owner. Additionally, the proposal would treat distributions (other than to the deemed owner or spouse) during the life of the deemed owner and the termination of grantor trust status during the life of the deemed owner as completed gifts.

The proposal would apply to trusts created on or after the date of the enactment of this provision and to any portion of a trust established before the date of enactment that is attributable to a contribution made on or after such date.

Valuation Discounts

Valuation discounts, such as marketability discounts and minority interest discounts, are allowed for transfers of nonbusiness assets for estate and gift tax purposes. The proposal would eliminate valuation discounts for certain transfers of nonbusiness assets for estate and gift tax purposes. Nonbusiness assets are defined as passive assets that are held for the production or collection of income and are not used in the active conduct of a trade or business. The proposal would apply to transfers after the date of the enactment of this Act.

PROPOSED RETIREMENT PLAN CHANGES

Annual Contributions

Annual contributions to retirement plans are not currently limited by the value of retirement plans owned by a taxpayer. The legislation would prohibit contributions from "applicable taxpayers" to retirement plans such as defined contribution plans, 403(b) and 457(b) plans, traditional and Roth IRAs if the total value of all the taxpayer's appliable retirement accounts exceed $10 million at the end of the prior year. Applicable taxpayers are defined as married individuals filing joint with incomes greater than $450,000 and single filers with incomes greater than $400,000. Both the $10 million and income thresholds are indexed for inflation for subsequent tax years and the proposal would be effective for tax years beginning after December 31, 2021.

Required Minimum Distributions

There is no current requirement for taxpayers to take additional distributions based on the value of their retirement accounts. The proposal would require applicable taxpayers, as defined above, with aggregate vested balances more than $10 million to take a minimum required distribution equal to 50% of the amount in excess of $10 million. This would mean a hypothetical taxpayer that has a balance of $12 million in retirement plans at the end of a tax year would be required to take a $1 million distribution in the subsequent tax year.

Additionally, if the taxpayer's combined retirement plan account balances exceed $20 million, the taxpayer would be required to take distributions equal to the lesser of (1) the aggregate plan balances more than $20 million or (2) the aggregate balances in Roth IRAs and designated Roth accounts in defined contribution plans. Once the funds have been distributed under this rule, the taxpayer would be allowed to determine from which retirement accounts to take distributions to satisfy the 50% distribution rule for balances above $10 million. These proposals would take effect for tax years beginning after December 31, 2021.

"Back Door" Roth IRAs

A popular strategy for taxpayers with incomes exceeding the Roth IRA contribution threshold , is to make non-deductible contributions to a traditional IRA, and shortly thereafter convert the nondeductible contribution to a Roth IRA. Taxpayers are also currently able to make Roth 401(k) plan contributions regardless of income limits, including non-Roth after-tax contributions that can currently be converted tax free to a Roth IRA. The proposal would prohibit applicable taxpayers from engaging in these "back door" Roth IRA strategies.

Under the proposal, applicable taxpayers would be prohibited from making Roth conversions, for both IRAs and employer-sponsored plans such as 401(k) plans. This would not take effect until December 31, 2031 (10 years from now). However, effective January 1, 2022, all employee after-tax contributions in tax-qualified retirement plans would be prohibited and non-deductible IRA contributions would no longer allowed to be converted to Roth accounts. This change would apply to all income levels.

IRAs and Accredited Investor

The proposed legislation would prohibit IRAs from holding any security that requires the IRA owner to be an accredited investor. This proposal would be effective for taxable years beginning after December 31, 2021, but with a two-year transition period for investments already held in an IRA as of the date of enactment.

IRAs and Self-Dealing

To prevent self-dealing, the proposal would expand the definition of “prohibited investments” in an IRA to include investments in which the IRA owner has a substantial interest. A substantial interest is defined as (a) a direct or indirect interest in investments not tradeable on an established securities market in which the IRA owner has at least 10% of the (i) combined voting power or value of all classes of stock, (ii) capital or profits interest of a partnership, or (iii) beneficial interest of a trust or estate; or (b) a corporation, partnership, or other unincorporated enterprise in which the IRA owner is an officer or director (or holds a similar position). The proposal makes this provision a requirement to be a valid IRA.

PROPOSED BUSINESS CHANGES

Corporate Tax Rates

Under current law there is a flat tax rate of 21% on net income for corporations. Under the proposal, there would be three corporate tax brackets:

  • 18% for taxable incomes under $400,000
  • 21% for taxable incomes over $400,000 and less than $5 million
  • 26.5% for taxable incomes greater than $5 million

A 3% surcharge would also apply to corporate taxable incomes greater than $10 million, with a cap of $287,000, i.e. the 3% surcharge applies to taxable incomes between $10 million and $19,566,666. These changes would take effect for tax years beginning after December 31, 2021.

Qualified Small Business Stock

In an unexpected move, the current 75% and 100% exclusion rates for gains realized from the sale of certain Qualified Small Business Stock (QSBS) would not apply to taxpayers with AGI of more than $400,000 or to trusts and estates. This change also has the effect of potentially making some of the gains from dispositions of QSBS subject to Alternative Minimum Tax. This change would affect sales and exchanges after September 13, 2021.

Excess Business Loss Limitation

Under a temporary provision, excess business losses of non-corporate taxpayers more than $500,000 for joint filers ($250,000 for all other taxpayers) are disallowed and treated as net operating losses in the following year; however, the provision is set to expire on December 31, 2025. The proposal would make the temporary provision permanent and modify how a disallowed excess business loss (EBL) is treated. Instead of treating the disallowed loss as a net operating loss in the following year, the EBL would be treated as a deduction attributable to a taxpayer’s trades or businesses when computing the EBL in the subsequent year. The proposal would be effective for taxable years beginning after December 31, 2020.

Free S Corporation Conversions

This unexpected provision would allow S corporations formed on or before May 13, 1996, to reorganize tax-free as partnerships if they liquidate completely and transfer substantially all its assets and liabilities to a domestic partnership between December 31, 2021, and December 30, 2023.

Conservation Easements In Pass-Through Entities

This proposal would disallow charitable deductions for contributions of conservation easements by partnerships and other pass-through entities if the contribution exceeds 2.5 times the sum of each partner's adjusted basis in the partnership related to the donated property. There would be an exception if they meet the requirements of the three-year holding-period rule or if they are contributions by family partnerships. There is work to do on this proposal to make it fair and administrable.

International Tax Provisions

The bill would reduce the Sec 250 deduction for global intangible low-taxed income (GILTI) to 37.5%, which results in an effective tax rate of 16.5% based on a corporate tax rate of 26.5%. GILTI would be calculated on a country-by-country basis.

NOTABLE UNCHANGED ITEMS

There were no changes to the limit on individual itemized deductions for state and local taxes (SALT), which has been capped at $10,000 since 2018. There has been significant discussion on Capitol Hill, particularly among representatives from high tax states, to reform the SALT cap, but nothing has yet been agreed upon.

Another omission from the draft; there were no provisions to end or modify tax-free step-up in basis upon death that had been proposed by the Biden administration.

CONCLUSION

All the above items are subject to change during negotiations currently underway in Congress. HHM will continue to monitor and keep you informed on this proposed tax legislation as developments progress.