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September 17, 2021

Build Back Better tax proposals would affect higher-income individuals, as well as trusts and estates

Recently proposed tax law changes in the Build Back Better Act reconciliation bill (the Bill), which were approved by the House Ways & Means Committee, would affect individual taxpayers' income tax and estate and gift tax obligations, as well as their retirement plans. Key proposed changes of interest for individual taxpayers would:

  • Increase the top capital gains rate to 25%
  • Return the top individual income tax rate to 39.6%
  • Expand the net investment income tax (NIIT) to cover net income derived in the ordinary course of a trade or business for taxpayers with greater than $400k (single filer) or $500k (joint filer) in taxable income
  • Charge a 3% surtax on an individual's modified adjusted gross income (AGI) in excess of $5m
  • Increase the three-year carried interest holding period enacted under the Tax Cuts and Jobs Act of 2017 (TCJA) to five years
  • Allow the TCJA-doubled estate tax exemption to expire after 2021, rather than after 2025
  • Change how and when grantor trusts are taxed for gift and estate tax purposes and treat sales to grantor trusts as income taxable events

A table at the bottom of this Alert summarizes the Bill provisions covered below, including their anticipated revenue mark, the income thresholds to which they apply and effective dates.

Individual Income Tax Provisions

Overall, the individual income tax provisions are expected to raise approximately $924b over the next 10 years.

The provisions discussed in this Alert are not the only provisions in the bill that would affect individual taxpayers. For example, individuals would be affected by the limitation on IRC Section 163(j) interest carryforwards to five years and various international provisions applicable to closely held businesses that operate in pass-through form and are owned by individuals, estate and trusts, but those provisions are not covered here.

1. Marginal rate increases from 37% to 39.6%

SUMMARY:This provision of the Bill (section 138201) would increase the top marginal individual income tax rate in IRC Section 1(i)(2) to 39.6%. It applies to: married individuals filing jointly who have taxable income exceeding $450k; heads of households with taxable income exceeding $425k; unmarried individuals with taxable income exceeding $400k; married individuals filing separately with taxable income exceeding $225k; and estates and trusts with taxable income exceeding $12.5k. These changes would apply to tax years that begin after December 31, 2021.

IMPLICATIONS: This provision was widely expected, and largely follows the Biden Greenbook proposal. For decedents dying during 2021, it would likely make sense for the estate to elect a fiscal year that ends as far into 2022 as possible to capture the current 37% rates as long as possible.

2. Capital gains at 25%

SUMMARY: This provision (section 138202) would increase the capital gains rate in IRC Section 1(h)(1)(D) to 25% for tax years ending after the Bill's introduction date. Under a transition rule, the current 20% rate would continue to apply to (1) gains or losses for the portion of a tax year preceding the Bill's introduction date, and (2) gains that are recognized after the introduction date and stem from a transaction entered into under a binding contract before the introduction date. These changes would apply to tax years ending after September 13, 2021.

IMPLICATIONS: Although many anticipated a change in the capital gains rate, this proposed rate is lower than the proposal in the Biden Greenbook of 39.6%. Nonetheless, combined with other provisions of the Bill (e.g., the 3.8% NIIT and the 3% surtax for income over $5m), the effective rate is closer to 31.8%. The rate would continue to be graduated but the top rate would apply for taxpayers with taxable income exceeding $400k.

This provision has a transition rule because the proposed effective date is September 13, 2021 (the date of the legislation's introduction). The transition rule seems to be designed to permit taxpayers to continue to be taxed under the current applicable capital gains rates if they entered into binding contracts for sale before September 13, 2021, but closed the sale before year-end. There is no guidance yet on what would qualify as a binding commitment to sell. For example, is a binding letter of intent sufficient? The 25% rate also seems to extend to taxes on qualified dividends and personal holding company and accumulated earnings. For decedents dying during 2021, it would likely make sense for the estate to elect a fiscal year that ends as far into 2022 as possible to capture the current lower capital gains rates for as long as possible.

3. Changes to IRC Section 1202

SUMMARY: This provision (section 138150) would amend IRC Section 1202(a) to provide that the special 75% and 100% exclusion rates for gains realized from certain qualified small business stock (QSBS) will not apply to taxpayers with AGI equal to or exceeding $400k. The baseline 50% exclusion in IRC Section 1202(a)(1) would remain available for all taxpayers. The amendments made by this section would apply to sales and exchanges after September 13, 2021, subject to a binding contract exception.

IMPLICATIONS: IRC Section 1202, better known as the QSBS exemption, would be significantly limited. Essentially, qualifying QSBS stock had two benefits: (1) excluding potentially 100% of gains and (2) enabling the roll-over of gain into qualifying IRC Section 1202 stock under IRC Section 1045. The proposed modifications would eliminate the 75% and 100% exclusion rates from taxpayers with AGI exceeding $400k. Likewise, the rollover under IRC Section 1045 would be limited to the applicable exclusion percentage of the original QSBS. Like the proposed change in capital gains rates, this provision has a transition rule because it would apply to sales and exchanges after September 13, 2021, with the same binding-commitment exception.

4. NIIT changes

SUMMARY: Amending IRC Section 1411, this provision (section 138203) would expand the NIIT to cover net investment income (NII) derived in the ordinary course of a trade or business for (1) individuals with taxable income exceeding $400k (single filer) or $500k (joint filer), and (2) trusts and estates. The provision clarifies that this tax is not assessed on wages to which FICA already applies. These changes would apply to tax years that begin after December 31, 2021.

IMPLICATIONS: A provision similar to this one was included in the Biden Greenbook proposal, along with changes to the self-employment tax regime. Congress likely appreciated that changes to the self-employment tax regime cannot be accomplished through the budget reconciliation process, so its only avenue was to modify the NIIT system by making it a three-tier tax system for individuals as shown on the following chart:

Taxpayer income limits

Tax system

AGI < $250,000

Not subject to NIIT

AGI = $250,001 — $399,999

Subject to current NIIT rules

"Taxable income" > $400,000

Subject to "new" NIIT

This "new" NIIT would cause NII to increase by including a business's nonpassive operating income that is not subject to self-employment tax. It would also include gains from sales of business assets used in nonpassive businesses, as well as all gains from sales of S corporations and partnerships. While presumably intended to increase NII, the proposed "new" system would also cause nonpassive losses that were previously excluded to be included. As the provision does not include an exception to the NIIT for material participation, more taxpayers would be captured under the new NIIT.

The provision attempts to simplify rules under Treas. Reg. Section 1.1411-10 for controlled foreign corporations and passive foreign investment companies but leaves the IRS to handle transition rules between the regimes.

The provision appears to deny trusts and estates the benefit of the middle tier of NIIT. In other words, trusts and estates with income above the threshold would be subject solely to the new NIIT regime. However, Congress might not realize the problems that could arise if the trust is subject to the new NIIT regime and the beneficiary is subject to the current NIIT. Therefore, the downstream consequences for beneficiaries would need to be corrected either via statute or IRS guidance (although the legislation does not grant the IRS specific legislative regulation writing authority, which could be problematic if the legislation is enacted as-is).

5. Change in holding period for IRC Section 1061 gain

SUMMARY: This provision (section 138149) would modify IRC Section 1061 by (1) generally extending from three to five years the holding period required for gain attributable to an applicable partnership interest to qualify for long-term capital gain treatment; (2) extending IRC Section 1061 to all assets eligible for long-term capital gain rates; (3) adding rules for measuring the three- or five-year holding period, including for tiered partnerships; and (4) modifying rules applicable to sale or exchange transactions. These changes would apply for tax years beginning after December 31, 2021.

IMPLICATIONS: Although many anticipated a change in the taxation of carried interest, this proposal retains capital gain treatment for carried interests. The provision would generally extend the holding period of carried interest (applicable partnership interest) from three to five years to qualify for long-term capital gains rates (i.e., under the new proposal to the new capital gains rate to 25%). The provision would retain the Biden proposal to not raise taxes on those making under $400k of AGI by retaining the three-year period for those taxpayers. But it is uncertain when that period would be tested — for example, is it $400k in the year the taxpayer sells, the whole period, or the beginning of the period? The provision would also add rules regarding tiered partnership that historically have caused confusion when a triggering event has occurred Finally, the provision seems to include all long-term capital gains, which could complicate sales of items such as IRC Section 1256 contracts with long-term capital gain components.

6. Section 199A limited deduction

SUMMARY: Amending IRC Section 199A, this provision (section 138204) would limit the maximum allowable deduction to $500k for a joint return, $400k for an individual return, $250k for a married individual filing separately, and $10k for a trust or estate. These limits would apply for tax years beginning after December 31, 2021.

IMPLICATIONS: During the process of lowering the corporate rate to 21% in the TCJA, a widening gap emerged between corporate and partnership tax rates. To try to balance the rate differential on certain types of property, IRC Section 199A was introduced, providing a 20% deduction (effectively lowering the ordinary income rate to under 30%). For individuals owning qualifying businesses, the proposed limitation of this preference would raise rates by 40%. The pass-through rate would essentially be the 39.6% individual rate, plus 3.8% NIIT, plus 3% surtax on income over $5m, creating a 46.4% total tax rate, plus any applicable state tax rates.

It is a little unexpected to propose sweeping estates into the same deduction limit as trusts. The legislation appears to address the use of multiple trusts to enhance the current 199A deduction. However, estates cannot engage in the same type of "gaming" as trusts, and the proposed limit here seems unnecessary. For example, if a taxpayer owned 199A property individually, the taxpayer would receive up to a $500k deduction. If the taxpayer dies in 2023, the taxpayer's estate holding the same property would receive a $10k deduction. When the estate distributes the asset to the beneficiaries, they receive up to a $500k deduction in 2023. This result seems to be unexpected.

7. IRC Section 461(l) limits

SUMMARY: Amending IRC Section 461(l), this provision (section 138205) would permanently disallow noncorporate taxpayers from claiming excess business losses (i.e., net business deductions exceeding business income). However, disallowed losses could be carried forward to the next tax year. These changes would apply for tax years beginning after December 31, 2020.

IMPLICATIONS: In its summary of the proposal, the House Ways & Means Committee does not highlight that any net operating loss (NOL) created by the application of IRC Section 461(l) is retested every year. Congress adopted the California-461(l) model, which treats the carryover losses as excess business losses and not as NOLs and has been in existence since 2018. This differing treatment of the loss carryover means that the business losses, even carryovers, will be limited to $500k per year. For example, consider a taxpayer who in year 1 has $2m in excess business losses. In year 1, those losses would be limited to $500k and $1.5m would carry forward to year 2. In year 2, the taxpayer has $0 in excess business losses and $0 in business income; under the new 461(l), only $500k would be deducted as an excess busines loss and $1M would carry forward to year 3. In no case can an individual have greater than a $500k loss in any given year. However, NOLs not created by IRC Section 461(l) (or so-called natural NOLs) are not subject to testing under this rule.

8. 3% surtax

SUMMARY: This provision (section 138206) would add IRC Section 1A to impose a 3% tax on a taxpayer's modified AGI that exceeds $5m for couples filing jointly ($2.5m for a married individual filing separately). The surtax would apply to estates and trusts with AGI greater than $100k. "Modified AGI" is AGI reduced by any deduction allowed for investment interest (defined in IRC Section 163(d)). These changes would apply to tax years beginning after December 31, 2021.

IMPLICATIONS: This would not be the first time that a surtax has been imposed on individuals. Surtaxes have come in many shapes and forms over the last century. The most interesting part of this surtax is the base on which the tax would be imposed.

The tax would apply to AGI less investment interest expense. Therefore, charitable deductions would not be deductible for this tax (except for a trust or estate, due to how AGI is defined for estates and trusts). This would increase the significance of determining which items are included in AGI and what may be claimed as itemized deductions. For example, this would encourage more individuals to partake in the SALT-workaround sanctioned by Notice 2020-75. In addition, the provision states that credits (general business credits, foreign tax credits, etc.) would not be allowed to offset the surtax.

Estate and Gift Tax Provisions

The Biden Greenbook did not contain estate and gift tax provisions, presumably because the gain-recognition-at-death provision in the Greenbook rendered them unnecessary. The Bill does not provide for gain recognition upon death. Instead, the Bill contains the following estate and gift tax provisions as revenue raisers. Overall, the gift and estate tax provisions are expected to raise approximately $82b over the next 10 years.

1. Lowering the estate/gift lifetime exemption

SUMMARY: This provision (section 318207) would terminate the temporary increase in the unified credit against estate and gift taxes, reverting the credit to its 2010 level of $5m per individual, indexed for inflation. This change would apply to decedents dying and gifts made after December 31, 2021.

IMPLICATIONS: Currently, the gift and estate tax exclusion is $11.7m, indexed for inflation. This amount would decrease to $5m but would still be indexed for inflation. In 2018, before its increase by the TCJA, the gift and estate tax exclusion was $5.6m, and would be approximately $6.3m for 2022.

This provision would affect a group of individuals sometimes referred to as the "working wealthy." For example, for a dual professional married couple with an estate of about $25m, the provision would cause their estate tax bill to go from virtually zero to approximately $4.8m. Of course, the same increase would happen to a married couple with a net worth of $3b but would serve more as a rounding adjustment on their estate and gift tax returns.

2. Estate tax valuation

SUMMARY: Amending IRC Section 2032A, this provision (section 318208) would increase from $750k to $11.7m the special valuation reduction available for qualified real property used in a family farm or family business. This reduction would allow decedents who own real property used in a farm or business to base the value the property for estate tax purposes on its actual use rather than on fair market value. This change would apply to decedents dying after December 31, 2021.

IMPLICATIONS: IRC Section 2032A allows the estate of a decedent to elect to value certain farm and business real property at a value based on how the property was and will be used in the future. In general, for estate tax purposes, property is valued at its highest and best use and not how the property was being used by the decedent. The proposed increase in this amount would equal the current estate tax exclusion and would benefit family farms and businesses.

3. Grantor trust inclusion

SUMMARY: This provision (section 138209) would create a new chapter (chapter 16) in subtitle B of the Code (which contains the gift, estate and generation-skipping transfer tax rules) and add new IRC Section 2901 to specifically address grantor trusts for gift and tax purposes. If the grantor were deemed the owner under the grantor trust rules (i.e., IRC Sections 671 through 679) of any portion of the trust, (1) the value of the grantor's gross estate would include the portion of the trust that the grantor was deemed to own at the time of death; (2) any distribution (other than to the deemed owner or the deemed owner's spouse) from a grantor trust during the grantor's life would be deemed a gift for gift tax purposes; and (3) all assets deemed owned by the grantor would be subject to gift tax if, during his or her life, the grantor ceased to be treated as owner of a grantor trust (i.e., upon "turning-off" grantor trust status). The amount included in the gross estate or treated as transferred by gift would be adjusted to the extent the transfer to the grantor trust was previously a gift for gift tax purposes. These changes would apply to (1) trusts created on or after the date of enactment, and (2) "any portion of a trust established before the date of enactment … [that] is attributable to a contribution made on or after such date."

IMPLICATIONS: This provision would effectively close the benefit of intentionally defective grantor trusts for estate and gift tax purposes, as it would subject a grantor trust to estate taxes (when the trust's deemed owner dies) or gift taxes (when grantor trust status is terminated while the deemed owner is still living). Further, it would negate the gift and estate tax benefit of any trust that has grantor status. For example, in spousal limited access trusts (SLATs) and grantor retained annuity trusts (GRATs), the appreciation of the assets in the trust would be subject to gift or estate tax upon the termination of grantor trust status, negating the benefit of having made an earlier taxable gift. In addition, proceeds of a life insurance policy that are owned inside an irrevocable life insurance trust, which is typically a grantor trust, could be subject to estate taxation if either the trust is established after the date of enactment or additional contributions are made after the date of enactment.

Should this provision pass, taxpayers with grantor trusts will need to significantly reexamine the grandfathered trusts for compliance with the new rules.

4. Taxable grantor trust sales

SUMMARY: The provision (section 138209, highlighted earlier in #3 as well) would also add IRC Section 1062, which would disregard the treatment of a deemed owner (under the grantor trust rules) of a trust as owner of the trust when determining whether a transfer between the deemed owner and his or her trust is a sale or exchange for income tax purposes. Regarding the disallowance of a loss in the case of a related taxpayer, IRC Section 267(b) would be amended to add a grantor trust and the trust's deemed owner to the list of related parties to which the related-party loss rule apply. These changes would apply to (1) trusts created on or after the date of enactment, and (2) any portion that was established by a trust before the enactment date and is attributable to a contribution made on or after that date.

IMPLICATIONS: This provision would effectively render obsolete Revenue Ruling 85-13 (regarding the nonrecognition of sales and exchanges between a grantor trust and its deemed owner), as it would subject these transactions to income tax when they occur. Two scenarios would be impacted by the elimination of Revenue Ruling 85-13. First, for "grandfathered" grantor trusts, future sales would no longer be a "tax nothing." Second, combined with the first provision of estate tax inclusion, future use of grantor trusts will be limited to nonexistent, because grantors will recognize gain if they sell assets to their grantor trust. However, the trust will still be subject gift or estate tax when the grantor dies, the trust makes a distribution, or the trust loses its grantor trust status.

Keep in mind that the provision would not be limited to individuals and transactions with grantor trusts. The provision would apply to all taxpayers that are treated as owners of grantor trusts — whether those trusts are charitable trusts, liquidating trusts, fixed investment trusts or employee benefit (rabbi) trusts.

5. Valuation of nonbusiness assets

SUMMARY: Amending IRC Section 2031, this provision (section 138210) would clarify that a valuation discount should not apply for transfer tax purposes when a taxpayer transfers nonbusiness assets. Exceptions are provided for assets used in hedging transactions or as working capital of a business. Under a look-through rule, if a passive asset consists of a 10% interest in some other entity, the provision would be applied by treating the holder as holding its ratable share of the assets of that other entity directly. These changes would apply to transfers occurring after the date of enactment.

IMPLICATIONS: This provision apparently aims to prevent family investment partnerships, which generally hold passive assets, from being discounted for gift and estate tax purposes. If a taxpayer creates a limited partnership with only investment assets and dies only owning limited partnership interests, the limited partnership wrapper would be disregarded in valuing its assets for estate tax purposes. The provision would apply broadly because it would apply to all entities in which a taxpayer owns at least a 10% ownership interest, except those that are actively traded (within the meaning of IRC Section 1092). This provision would prevent the layering of entities on top of each other as it provides for look-through rules.

Retirement Plan provisions

Overall, the retirement plan provisions are expected to raise approximately $6.2b over the next 10 years.

1. IRA contribution limits

SUMMARY: Current law allows taxpayers to contribute (but certain higher-income taxpayers may not deduct the contribution) to individual retirement accounts (IRAs), regardless of how much they have already saved in their IRAs. To avoid subsidizing retirement savings once account balances reach very high levels,this provision (section 138301) would create new rules for taxpayers with large balances in IRAs and defined contribution retirement accounts, effective for tax years beginning after December 31, 2021.

If the total value of an individual's balances in qualified defined contributions plans (such as 401(k) plans), 403(b) plans, governmental 457(b) plans and IRAs exceeded $10m at the end of the most recent calendar year that closed before the start of the individual's tax year, the provision would prohibit the individual from making additional contributions to a Roth or traditional IRA for a tax year. This rule would apply to (1) single taxpayers, or married taxpayers filing separately, with adjusted taxable income exceeding $400k, (2) married taxpayers filing jointly with adjusted taxable income exceeding $450k, and (3) heads of household with adjusted taxable income exceeding $425k; these amounts would be indexed for inflation.

Further, the provision would require employers to annually report any employer defined contribution plans with aggregate account balances of at least $2.5m (adjusted for inflation) by notifying both the IRS and the plan participant whose balance is being reported.

IMPLICATIONS: Although the $10m limit takes into account an individual's account balances under certain employer-based retirement plans (such as 401(k) plans) in addition to the individual's IRA account balances, only IRA contributions would be affected if the $10m limit is exceeded. For example, assume an individual has adjusted taxable income of $500k and a combined balance of $9.999m in employer-based defined contribution retirement plans in the previous year. Under this provision, the individual could only make a $1k IRA contribution during the year.

Under the same facts, however, no limit applies to the individual's IRC Section 401(k) contribution under this provision. But, a portion of the contribution would likely end up being purged in the following year under the new provisions of IRC Section 4974(e), described next.

2. IRA value purging

SUMMARY: If an individual's combined balance in traditional IRAs, Roth IRAs and defined contribution retirement accounts exceeded $10m at the end of the preceding calendar year and the individual exceeded the taxable income limits previously outlined (section 138301), this provision (section 138302) would require, for tax years beginning after December 31, 2021, at least 50% of the amount by which the aggregate balance exceeded $10m to be distributed in the next tax year.

If the combined balance exceeded $20m, the provision would require all of the excess to be distributed from Roth IRAs and Roth-designated accounts in defined contribution plans, up to the lesser of (1) the amount needed to lower the total balance in all accounts to $20m, or (2) the aggregate balance in Roth IRAs and designated Roth accounts in defined contribution plans. After the individual distributed the excess required under this 100% distribution rule, the individual could determine the accounts from which to distribute to satisfy the 50% distribution rule, described previously.

A new 35% mandatory withholding requirement would apply to amounts distributed under this provision, and these amounts would not be subject to the 10% early distribution tax under IRC Section 72(t).

IMPLICATIONS: The proposed IRC Section 4974(e) would change the required minimum distribution (RMD) rules.

As under current law, a taxpayer doesn't necessarily need to dispose of any investments to comply with RMD rules, but the taxpayer does need to remove them from tax-favored accounts, thereby triggering income tax.

To illustrate the mechanics, assume a taxpayer has $700k of adjusted taxable income, a $6m Roth IRA and $21m in his IRC Section 401(k) account at the end of year 1. In year 2, because the individual has $27m in total plan assets, he would need to purge the lesser of (a) $7m (the amount needed to get down to $20m), or (b) the Roth amount ($6m). Under step 1, he would be required to liquidate the entire Roth IRA account. Because it's a Roth IRA, the distribution would be nontaxable (assuming it is a qualified distribution).

After that step, the taxpayer would be left with $21m in his plans. Part 2 would then require him to distribute 50% of the amount in excess of $10m. This would result in a taxable distribution of $5.5m, which would be subject to mandatory withholding of 35% but would not be subject to the 10% additional tax under IRC Section 72(t).

In year 3, assuming no further change in balances, the individual would begin with an account balance of $15.5m ($21m - $5.5m). He would be required to take a taxable distribution of $2.75m (50% of the excess over $10m) from the IRA, subject to mandatory withholding of 35%. At the end of year 3, the account balance would be $12.75m.

Assume the prior facts, except that the individual made a $15k contribution to a Roth 401(k) during year 2. Recall, new proposed IRC Section 409B would only prohibit IRA contributions. Thus, assuming no appreciation, the taxpayer would have $15.515m going into year 3. Because the taxpayer's plan balances would not exceed $20m at the end of year 2, the taxpayer would not be required to purge any of the new Roth 401K amounts just contributed. However, the taxpayer would be required to distribute 50% of the excess over $10m from the 401(k) plan.

3. No Roth conversions

SUMMARY:This provision (section 138311) would end a higher-income taxpayer's ability to contribute to a Roth IRA through a conversion. Under current law, a single taxpayer whose income exceeds $140k may not contribute directly to a Roth IRA but may make a nondeductible contribution to a traditional IRA and then convert the contribution from the traditional IRA to a Roth IRA.

For tax years beginning after December 31, 2031, the provision would eliminate Roth conversions for IRAs and employer-sponsored plans for (1) single taxpayers, or married taxpayers filing separately, with adjusted taxable income exceeding $400k, (2) married taxpayers filing jointly with adjusted taxable income exceeding $450k, and (3) heads of household with adjusted taxable income exceeding $425k; these amounts would be indexed for inflation. In addition, the provision would prohibit all employee after-tax contributions in qualified plans and after-tax IRA contributions from being converted to Roth IRAs, regardless of a taxpayer's income level. This prohibition would be effective for distributions, transfers and contributions made after December 31, 2021.

IMPLICATIONS: Beginning in 2022, rollovers from non-Roth accounts into Roth accounts could only be comprised of taxable amounts. Therefore, the concept of making a $6k nondeductible IRA contribution and then rolling it into a Roth IRA would not be allowed because the $6k would be considered a nontaxable amount. However, a taxpayer could fund a nondeductible IRA with $6k on January 1 and rollover any appreciation on that amount every December under the rule.

Beginning in 2032, rollovers into all Roth accounts for higher-income taxpayers would be prohibited. This would include taxable amounts in IRAs as well as conversions inside of employer plans like IRC Section 401(k) plans.

4. No FSCs/DISCs in IRAs

SUMMARY: This provision (section 138503) would make owning a foreign sales corporation (FSC) or a domestic international sales corporation (DISC) a prohibited transaction that causes the IRA to lose its tax-exempt status if the FSC or DISC receives any commission or other payment from an entity owned by the IRA owner or beneficiary.

IMPLICATIONS: The purpose of this provision is to effectively overturn case law holding that a FSC and a DISC could be held in IRAs.

5. Other IRA items

a. Prohibiting IRA investments conditioned on account holder's status

SUMMARY: This provision (section 138312) would prohibit an IRA from holding any security if the issuer requires the IRA owner to (1) maintain a minimum level of assets or income, (2) have completed a minimum level of education, or (3) have obtained a specific license or credential. Effective for tax years beginning after December 31, 2021, an IRA that already holds these prohibited securities would have two years to move them out of the IRA, and an IRA that thereafter acquires a prohibited security would lose its IRA status.

IMPLICATIONS: Under this provision, an IRA could not hold unregistered securities offered only to accredited investors, thereby limiting a taxpayer's ability to invest in privately held companies through an IRA.

b. Expanding statute of limitations for IRA noncompliance

SUMMARY:This provision (section 138313) would expand from three years to six years the statute of limitations for IRA noncompliance related to valuation-related misreporting and prohibited transactions. The change would apply to taxes for which the current three-year period ends after December 31, 2021.

IMPLICATIONS: This provision would provide the IRS with additional time to enforce the rules on prohibited transactions and valuation reporting.

c. Prohibiting investment of IRA assets in entities in which the owner has a substantial interest

SUMMARY: Under current law, an IRA owner may not invest his IRA assets in a corporation, partnership, trust or estate in which he holds a 50% or greater interest. This provision (section 138314) would reduce the 50% threshold to 10% for investments that are not tradable on an established securities market, regardless of whether the IRA owner has a direct or indirect interest. The provision would also require that, to qualify as an IRA, the IRA may not invest in an entity in which the IRA owner is an officer. Although the provision would take effect for tax years beginning after December 31, 2021, a two-year transition period would be provided for IRAs that already hold these investments.

IMPLICATIONS: This provision would further limit an IRA owner's ability to own a closely held business through an IRA, including a Roth IRA.

d. Treating IRA owners as disqualified persons for purposes of prohibited transaction rules

SUMMARY: This provision (section 138315) would clarify that an IRA owner is always a disqualified person for purposes of applying the prohibited transaction rules to an IRA. This provision would apply to transactions occurring after December 31, 2021.

IMPLICATIONS: This provision would clarify that disqualified persons under the prohibited transaction rules include not only the original owner of an IRA, but also a designated beneficiary of that IRA after the original IRA owner dies or any other person for whose behalf an IRA is maintained.

Other unusual Provisions

The Bill includes two perplexing provisions that were unexpected. One provision would allow very old S corporations to convert to partnerships tax-free. This provision is expected to cost $4.8b over the next two years.

The second provision would disallow certain charitable deductions by codifying a listed transaction. The provision would affect many non-abusive transactions that look like syndicated conservation easement transactions but are not. This provision is expected to raise $12.5b over the next 10 years.

1. Free S corporation conversions

SUMMARY: This provision (section 138509) would allow eligible S corporations (i.e., those that were S corporations on May 13, 1996, before the check-the-box regulations were published) to reorganize tax-free as partnerships. The eligible S corporation must liquidate completely and transfer substantially all of its assets and liabilities to a domestic partnership between December 31, 2021 and December 30, 2023.

IMPLICATIONS: This provision was not on anyone's radar screen and did not appear in any prior Greenbook or guidance. Although S Corporations are treated as pass-through entities for tax purposes, additional restrictions apply to them, unlike for other passthrough entities. For example, the owner of the S corporation does not get additional outside basis for debt allocated to the shareholder and the shareholder is limited to the amount of outside basis before losses flowing up through the S corporation are suspended. Additionally, S corporations are subject to rules related to the types of shareholders and the manner in which distributions among the shareholders can occur. So, sometimes they act like a partnership and sometimes they act like a company.

Before 1986, the Supreme Court's decision in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), allowed a corporation to distribute appreciated property to its shareholders without gain. The provision would reinstate the General Utilities doctrine for certain types of S corporations for a limited period (two years).

Many of these old S Corporations would likely choose to transition under this proposal. However, the administrative guidance necessary to cope with the mismatched rules would be voluminous. For example:

  • What happens to IRC Section 1366 losses that are suspended inside the S corporation at the time of conversion?
  • What happens to suspended IRC Section 163(j) interest inside the S corporation at the time of conversion?
  • Would recourse or qualified nonrecourse debt newly allocated to the members free up suspended at-risk losses generated during the period the company was an S corporation?
  • Does the conversion trigger the indefinite IRC Section 965 transition tax deferral afforded to S corporation shareholders?
  • What happens to suspended passive losses and at-risk losses for deemed owners of qualified subchapter S trusts?
  • What happens to suspended foreign tax credits and investment interest expense carryovers inside the S-portion of an electing small business trust if the S portion is terminated?

2. Conservation easements in pass-throughs

SUMMARY: This provision (section 138403) would disallow charitable deductions for contributions of conservation easements by partnerships and other pass-through entities if the contribution exceeds 2.5 times (2.5X) the sum of each partner's adjusted basis in the partnership that relates to the donated property. Exceptions to this general disallowance include donations of property that meet the requirements of the three-year holding-period rule and contributions by family partnerships. Taxpayers would be given 90 days to correct defects in deeds. The provision generally would apply for contributions made after December 23, 2016; for easements related to certain historic preservation, the provision would apply for contributions made in tax years beginning December 31, 2018.

IMPLICATIONS: In this provision, Congress seems to be attempting to codify Notice 2017-10 (designating certain transactions involving syndicated conservation easements as "listed transactions") but went beyond the four corners of the Notice and would likely eliminate legitimate deductions in the process. Further, the provision would operate retroactively to catch any contributions made after December 23, 2016.

The following chart compares the factual elements required by Notice 2017-10 with the factual elements captured by the provision:

 Example facts

Required by Notice 2017-10

Covered by provision

Investor receives promotional materials, which may be oral or written



Charitable contribution deduction equal to or greater than 2.5X the investment


Yes, but the charitable contribution deduction is limited to 2.5X basis in the land donated

Investor purchases an interest, directly or indirectly (through one or more tiers of pass-through entities), in the passthrough entity that holds real property



Pass-through entity that holds the real property contributes a conservation easement encumbering the property to a tax-exempt entity and allocates, directly or through one or more tiers of passthrough entities, a charitable contribution deduction to the investor



Exemption for partners invested for more than three years

No, but implied


The most overreaching part of the provision is that would bar a deduction for any amount greater than 2.5X the basis in the donated land unless every partner, direct and indirect, has held the partnership interest for more than three years. There is no exception for gifts to individuals, charitable gifts, deaths, transfers into/out of trusts, estates, partnerships, corporations, or corporations. There is an exemption for family partnerships whose partners consist of spouses and (1) a child or a descendant of a child, (2) a brother, sister, stepbrother or stepsister, (3) the father or mother, or an ancestor of either, (4) a stepfather or stepmother, (5) a son or daughter of a brother or sister of the taxpayer, (6) a brother or sister of the father or mother of the taxpayer, or (7) a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law.

The family partnership rule does not include estate or trusts. So even if a taxpayer is a partner in a family partnership, and the father dies, the "estate" of the father is not an eligible partner, so the partnership would be denied a deduction for any easement made for at least the next three years if the fair market value is 2.5X basis.

For example, assume a family partnership has only parents, grandparents, and children as partners. The grandfather, a 22% partner, died in December 2017. At his death, the partnership held land worth $20m that was acquired in 1965 for $220k and marketable securities of $20m. In 2019, the partnership granted a conservation easement valued at $17m on the land. Because the rule is retroactive back to donations occurring after December 2016, the deduction reported on the 2019 individual tax returns of all the partners would be retroactively denied and would be treated as a gross valuation misstatement under IRC Section 6662, which carries with it a 40% penalty. At a 37% tax rate, the easement would yield an understatement of $6.29m for the family and a penalty of $2.5m.

Additionally, the provision would require indirect partners of upper-tier partnerships to also be invested for more than three years. This requirement would be inherently unadministrable by either taxpayers or the IRS because it would require the donating partnership to know if its indirect partners have been partners for longer than three years. This would require ownership information to flow from the top to the bottom of a tier structure, which is rarely administrable in the federal tax system. The provision could be greatly simplified by denying a deduction for any amount over 2.5X basis that was allocated to a partner/shareholder that was not a direct or indirect owner for the preceding three years. This would still allow the partnership to take the true value of the deduction but would turn the limitation into a partner-level limitation.

This should not be the result, but it appears to be. There is much work to do on this provision before it is fair and administrable.

Appendix - Table of provisions


Income threshold

Bill section no.


10-yr revenue

(in billions)

Effective date




Changes to IRC Section 1202


Sept. 13, 2021, w/ binding contract exception

AGI > $400k

All trusts/estates included


Marginal rate increases from 37% to 39.6%


Tax years beginning after Dec. 31, 2021

Highest rate bracket

Highest rate bracket


Capital gains at 25%


Sept. 13, 2021, w/ binding contract exception

Highest rate bracket

Highest rate bracket


NIIT changes


Tax years beginning after Dec. 31, 2021

Taxable income > $400k

All trusts/estates included


Change in holding period for IRC Section 1061 gain


Tax years beginning after Dec. 13, 2021

AGI > $400k

All trusts/estates included


IRC Section 199A limited deduction


Tax years beginning after Dec. 31, 2021




IRC Section 461(l) limits


Tax years beginning after Dec. 31, 2021




3% surtax


Tax years beginning after Dec. 31, 2021

>$5m AGI

>2.5m AGI (MFS)

>$100k AGI


Lowing estate/gift lifetime exemption


Tax years beginning after Dec. 31. 2021




Estate tax valuation


Deaths after Dec. 31, 2021




Grantor trust inclusion


Trusts created or funded after Dec. 31, 2021



Taxable grantor trust sales


Valuation of nonbusiness assets


Deaths after date of enactment





IRA contribution limits


Years beginning after Dec.31, 2021

Adjusted taxable income >$400k-450k



IRA value purging


Back-door Roth conversions


Years beginning after Dec. 31, 2021


Any Roth conversions

Years beginning after Dec. 31, 2031


Other IRA items


Generally after Dec. 31, 2021






Stock held on or after Dec. 31, 2021




Free S corp conversions


Between Dec. 31, 2021 and Dec. 30, 2023




Conservation easements in passthroughs


Contributions after Dec. 23, 2016








Contact Information
For additional information concerning this Alert, please contact:
Private Client Services
   • David Kirk (
   • Justin Ransome (
   • David Herzig (
   • Sean Aylward (
   • Todd Angkatavanich (
Compensation and Benefits Group
   • Stephen Lagarde (