May 4, 2021
President's first speech to Congress highlights potential changes for individual taxpayers
In his speech to a joint session of Congress on April 28, President Biden discussed Administration policy plans that are likely to affect individual taxpayers. The American Jobs Plan proposes significant investment in traditional infrastructure, and the American Families Plan focuses on "human infrastructure," such as education, daycare and healthcare.
The President described the Jobs Plan as creating jobs on projects like replacing lead pipes and building a modern power grid, generating well-paying jobs in the United States, many for blue-collar workers. He characterized the American Families Plan, which will cost approximately $1.8t, as addressing four of the biggest challenges facing Americans:
To pay for these investments in human infrastructure, the President advocates reforming corporate tax provisions to close "tax loopholes and deductions that allow for offshoring jobs and shifting profits overseas."
An Administration fact sheet, posted April 29, indicates that the plan's tax provisions directly affecting individuals would:
Although it is impossible to fully vet the potential implications of legislation that is currently a series of talking points on the Administration's fact sheet and not yet in draft form, understanding the parameters is nonetheless critical.
One of the best data points might be to compare the items in Candidate Biden's proposals to what has, and has not, made it into President Biden's proposals.
* LTCG = long term capital gain
Comparing these proposals of Candidate Biden and President Biden, there are a few common threads and there are also some notable differences. One common thread not readily apparent from the chart above is the lack of detail in the proposals. The most basic detail that is omitted is the proposed effective date — are we going back to 1/1/21, a mid-year point in 2021, or truly prospective to 2022?
"Those making over $400,000"
Candidate Biden stated on multiple occasions that he will not raise taxes on those making less than $400,000. It appears that the White House press release, more or less, follows that theme, proposing raising the top individual rate to 39.6% for those making over $400,000. But the proposal does not actually make this demarcation point clear — is it:
Clarification would help taxpayers and tax professionals understand the proposed changes.
Increased capital gain rates (and qualified dividend income?)
The centerpiece of the proposal states that "[h]ouseholds making over $1 million … will pay the same 39.6% rate on all their income, equalizing the rate paid on investment returns and wages." The press release does not mention that such parity between the tax rate on income and capital gains has not existed in the US for about 100 years.
Another example of a detail missing from the Administration's proposal is how the $1m threshold would be calculated. As in the prior example for calculating the $400,000 income number, there are multiple ways to arrive at $1m in income. However, this piece has a twist. If an individual has $800,000 of wages and $300,000 of LTCG and QDI, he or she is presumably making more than $1m under the President's definition. But the simplest question cannot be answered: does the fact that the individual has income over $1m cause $100,000 of the income to lose LTCG/QDI status, or does it cause the entire $300,000 to lose LTCG/QDI status? In this case, there is a $58,800 difference between the two approaches. Such a difference may create an incentive for borderline taxpayers to, for example, defer other income (such as making deductible 401(k) contributions versus Roth 401(k) contributions) to get their income below the threshold.
What else should be considered?
Presumably, the proposal's reference to LTCG rates contemplates something broader than the true 20% LTCGs. One would think that it also includes unrecaptured IRC Section 1250 gain taxed at 25% and collectibles gains taxed at 28%. Although the proposal would apparently equalize the tax rate paid on investment returns and wages, basic tax concepts, such as holding period, capital-loss limitations, limitations on investment interest expense, and the 60%/40% split on IRC Section 1256 contracts, would remain in place for those making under $1m. Would they continue to apply for those making over $1m? From a policy perspective, deductions for investment interest expense and capital losses are limited so that certain investment expenses do not offset wage income. By equalizing the rate paid on investment returns and wages, the policy reasons for those limitations would arguably disappear. Removing those limitations for individuals making over $1m while leaving them in place for those making under $1m, however, would result in a multitiered tax system in which different sets of rules apply to different sets of taxpayers. Due to the annual accounting period, some taxpayers on the cusp of $1m might not know what set of rules applies until the return is complete.
Other items omitted from the President's proposal raise questions as well. For example, would the concept of qualified dividends disappear, and how would the LTCG rates be addressed?
Changes to NIIT
The changes to NIIT are among the most perplexing aspects of the Administration's proposal. The following example assumes a married couple filing jointly:
Of course, one assumes that "those making over $400,000" means those with AGI exceeding $400,000, because the NIIT system is based on modified AGI. Nonetheless, this is uncertain. Setting aside the AGI-versus-taxable-income issue, proposal is assumed to be taxing non-passive business operating income. If this is the intent, wouldn't it be simpler to repeal the NIIT entirely and replace it with a system that imposes a 3.8% tax on all income, less amounts subject to SECA and FICA? This solution would probably produce the same economic result but eliminate 300 pages of complicated rules and regulations and a parallel tax system that many would love to forget. (This probably should have been done in 2010, but now the proposal doubles down on a system that was complicated and a bit awkward from the start.)
Other items — IRC Section 1031, carried interest and business loss limitations
President Biden also proposed to eliminate tax benefits for real-estate investors, e.g., IRC Section 1031. In 1031 exchanges, capital gains and depreciation-recapture taxes can be deferred if the proceeds of the sale are used to purchase another property within 180 days. The Administration's proposal would eliminate the ability to do this when capital gains are greater than $500,000. Does this mean $500,000 per taxpayer? For example, is the exemption for spouses a total of $1m? Or, if it is sold in a partnership, does each partner get a $500,000 exemption and a partnership with 20 partners gets a $10m exemption? How does this interact with depreciation-recapture taxes? For more, see this QUEST Report on 1031 exchanges.
The issue of carried interest repeal — or maybe it's better called a replacement for IRC Section 1061 — seems largely unnecessary if the rate increases on LTCG and QDI come to fruition. Of course, repeal of carried interest would apply to those making under the $1m threshold, but a vast majority of those receiving carried interest are above the $1m threshold. Perhaps the Administration views the repeal of carried interest as a backup proposal if the LTCG/QDI rates cannot get to 39.6%.
The proposal to make permanent the business loss limitation in IRC Section 461(l) is interesting. The loss has typically created a one-year deferral of deductions because disallowed deductions become usable NOLs in the following year (subject to an 80%-of-taxable-income limit). The revenue impact for the government of a taxpayer's deferring deductions from one year to the next should be negligible, so there seems little reason to make the business loss limitation permanent.
Estate tax reform
It is surprising that the White House proposal did not include direct changes to the estate and gift tax regime. Earlier, it had seemed that a proposal to reduce the estate tax exemption and increase the rate was a forgone conclusion, but individuals and estate planners can relax for the time being.
However, by keeping the estate and gift tax regime and proposing elimination of basis step-up at death, the estate tax effectively becomes a wealth tax due at death. It is not surprising that the elimination of the step-up in basis made it into the final plan. Recall that a no-step-up regime has been attempted several times in the past and only once actually became applicable (calendar year 2010). For more information, see this QUEST report on basis step-up in inherited assets.
In evaluating this proposal to eliminate the step-up in basis, it is worth looking at what the status quo really is. Many people of significant means have already done comprehensive estate planning in which assets are outside of their estates and held in dynastic trusts intended to go on for generations. These assets were never going to get a step-up in basis — it was the part of the deal, along with exchanging estate tax liability for an income tax liability down the line. So, the population that would be most affected by eliminating the step-up in basis are those who did not adequately plan (or didn't have the right asset mix to plan most effectively) and therefore are subject to express double taxation — the estate tax and income tax due to carryover basis. Of course, there is a small mechanism to eliminate this in the gift tax cases — namely a basis increase for gift taxes paid — that should be considered in this new proposed construct for estate tax paid.
While more details on the tax proposals will come in the Administration's FY2022 budget, expected to be released sometime in May, the long-awaited rollout of the two-part plan is now complete, and the President has put his cards on the table on tax increases.
The Families Plan almost certainly requires budget reconciliation as it contains mostly Democratic priorities. One way or another, the budget reconciliation process will most likely be used and nearly all Democrats in Congress must agree to the same package.
The first key decision for Democrats will focus on the size of the reconciliation bill, and how much of it will be offset with tax increases. That decision must ultimately find its way into a budget resolution that must be agreed to by the House and Senate before actual drafting of the reconciliation bill can get started.